Knight Capital Group Inc. Q3 2009 Earnings Call Transcript

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Knight Capital Group Inc. (NASDAQ:NITE) Q3 2009 Earnings Call October 21, 2009 9:00 AM ET


Thomas Joyce - Chairman & Chief Executive Officer

Steve Bisgay - Senior Managing Director & Chief Financial Officer

Jim Smyth - Executive Vice President

Greg Voetsch - Executive Vice President

Marge Wyrwas - Senior Managing Director of Communications, Marketing, and Investor Relations


Rich Repetto - Sandler O’Neill

Rob Rutschow - CLSA

Roger Freeman - Barclays Capital

Daniel Harris - Goldman Sachs

Chris Allen - Pali Capital

Ken Worthington - JP Morgan


Good day and welcome to the Knight Capital Group third 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, Steve Bisgay. As a reminder, we will be conducting a question and answer session following the presentation.

Now to kick off our program I’d like to turn the call over to Marge Wyrwas, Senior Managing Director of Communications, Marketing and Investor Relations. Please go ahead.

Marge Wyrwas

Good morning ladies and gentlemen, I’m Marge 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 e-mail and fax list please contact a member of the CMIR team.

I am pleased to welcome you to Knight’s third quarter 2009 conference call and webcast. With me in the room today are Tom Joyce, Chairman and CEO, and Steve Bisgay, Senior Managing Director and CFO who will make formal remarks.

Jim Smyth, Executive Vice President and Greg Voetsch, Executive Vice President are also in the room. 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 affecting results of operations and risk factors, as well as 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, 2008, and in other reports or documents that company files with or furnishes to the SEC from time to time.

A final note before we start. Knight will host its annual analyst and investor meeting on Monday, November 2. The meeting will be webcast live for all interested parties beginning at 10:30 am Eastern Time and ending at noon. To access the webcast go to at least 10 minutes before the start. We hope you can all join us.

Now I will turn the call over to Knight’s Chairman and CEO, Tom Joyce. TJ.

Tom Joyce

Thanks Marge, and good morning everybody. The third quarter 2009 was a period of relative calm in the capital markets in contrast to the past two years. The financial sector appears to have stabilized as evidenced by the continued improvement of the Dow Jones US financial sector index.

We witnessed increased activity among retail investors and equities and the larger firms and Wall Street showed signs of regrouping. All this combined to have produced an interesting quarter for Knight. We worked constantly to consolidate market share gains across our equity businesses.

As well we continue to take share in fixed income as we enjoyed solid expansion in that business. We also grew geographically adding clients in both Europe and Asia across equities, fixed income and foreign exchange and in an effort, key to our continued future growth, we invested in important initiatives such as capital markets, options market making and self-clearing.

However, we also saw some of our competition attempt to reassert itself. We pride ourselves on providing on some of the best execution statistics in the industry and as we saw others enter the market we ramped up our performance to maintain that standard. The end result was that payment for order flow increased as did our commitment to improving prices for our clients. As well the increased volumes we attracted raised our execution and clearance expense.

And finally, we saw a mix shift in our business, thanks to the terrific growth in our fixed income platform. The end result is that margin slipped during the quarter.

Now a brief summary of our financial results: In the third quarter of 2009, Knight recorded earnings from continuing operations of $0.32 per diluted share. Global markets contributed pretax operating income of $58.5 million and the corporate segment recorded a pretax loss of $8.8 million. Total revenues from continuing operations for the second quarter of 2009 were $299.9 million compared to $240 million for the third quarter of 2008.

Pretax operating income from continuing operations for the third quarter was $49.8 million compared to $69 million for the third quarter of 2008 and pretax operating margins from continuing operations for the third quarter of 2009 were 18% compared to 23% for last year’s third quarter.

Looking at global markets, during the third quarter of 2009 revenues in global markets increased 18% over the third quarter of 2008, while pretax operating income decreased 34%. Pretax operating margins were 20% compared to 35% in the third quarter of 2008. In equities the brokerage dealer group successfully retained industry leading market share despite renewed competition from traditional competitors and new entrants alike.

Net trading revenues are up 17% for the first three quarters of 2009 versus ‘08, as we witnessed increased activity from some of the retail investing base in the growth of our electronic trading strategies. We have been able to sustain our market share through a consistent focus on our clients, investments and execution quality and competitive payment for referral.

While our focus and stability created a natural competitive advantage through the turbulent times of 2008, we have seen the competition retrenched themselves in 2009, investing and execution quality and actively marketing to the sales side client base that we share.

In addition, we have begun to see hands of new competition from historically prop only high frequency trading businesses and large diversified financial institutions alike.

While the cost of effectively competing naturally impacts profitability, rising volumes and increased regulatory transaction fees have compounded margin pressure. With our NASDAQ enlisted customer share volume increasing dramatically from 2008, and the concentration of this volume and lower price stocks doubling we saw our execution and clearance expenses rise.

Although the cost to competing has increased in recent quarters we remain committed to maintaining our leadership position in equity market making. We continue to believe that Knight offers a unique competitive advantage to our clients, the ability to trade all equities with unparallel financial liquidity, and execution quality throughout market cycles.

Recently, we have begun to see a rebound of the investor appetite for risk, as the concentration of activity in large cap listed stocks seems to have shifted to technology, biotech and even the Bulletin Board sector.

Our client service and trading technology provide a seamless and easily scaleable solution for our clients. Along that theme, Knight Link has witnessed an increase in competition of weight. To briefly recap, we launched Knight Link in September of 2006 as a rapid low cost service handling unmatched orders, which we call Exhaust from the larger firms on Wall Street and please bear in mind that Knight Link is a dark pool but rather an extension of our market making business.

The power is the simplicity of the Knight Link concept in combination with our unparallel liquidity, high speed trading technology and ability to provide consistent high quality trade executions. Knight Link provides clients with tremendous utility of the cost saving alternative for the exchanges and ECMs.

Well, as a result of Knight Link’s success the idea really caught on. Today there are approximately 25 firms with knock off products targeting similar order flow. We have managed to continue growing trade volumes by standing the market. We are going to continue increasing penetration with existing clients in providing consistent high quality trade executions. In short, we’ve worked awfully hard to become as indispensable and possible and we won’t quit.

Staying in equities, the institutional sales and trading team continued to enjoy gains in market share earned, since the onset of the turmoil on Wall Street. Year-to-date, we have opened accounts that are faster paced in 2008 and increased penetration of existing clients. As a result, our equity commissions dipped only slightly year to date through the third quarter. At the same time, the size of the US institutional equity commission wallet fell by approximately 20%. So, clearly we are picking up share.

We have one of the largest sales and trading teams in the institutional equity business with about 200 professionals globally and over 2,000 clients. The combination of our deep unique pool of liquidity and some of the top talent on the street allowed us to continue to expand our relationships with our clients.

Domestically, our market share has increased this year. A big highlight has been the addition of one of the leading ETF teams in the industry, thanks to their efforts, our market share and ETS has more than doubled in the past six months.

In Europe, while exchange volumes continue to be down year over year, our established team enjoyed a rebound this quarter and in Asia we are opening new account on a weekly basis, positioning us for success in that critically important region.

Especially noteworthy in this quarter, were the accomplishments of the electronic sales teams. Knight Direct our electronics suite of products is experiencing strong growth as we have added clients and new trading strategies such as our new Oasis product. In foreign exchange our Hotspot offering is picking up market share in a period where both EBS and the CME have lost shares, both Knight Direct and Hotspot are enjoying record volumes.

In aggregate, during the third quarter of 2009, we had average daily US equity trade volumes of $3.9 million, average daily share volume of $13.2 billion and average daily dollar volume traded of $24.2 billion. Comparing totals from the first three quarters of 2008 to the first three quarters of 2009, we experienced an increase of 93% in average daily trades, a 130% in daily share volume and 24% in daily dollar value traded.

The staggering share volumes we witnessed during the third quarter are due to the heightened trading activity and low price listed in NASDAQ stocks as well as Bulletin Board and Pink Sheets. In the third quarter of the 2009, Knight was once again the leader in off-exchange liquidity in US equities. Our text rank Knight, number one in shares traded or listed, shares traded of NASDAQ, and shares traded of Bulletin Board securities among our peers by share volume.

Turning to fixed income, Knight’s institutional fixed income research, sales and trading team had a record quarter from a revenue standpoint. During the quarter, the number of trading relationships rose to 2100 in comparison to about 700 at the close of the third quarter of 2008.

Average daily dollar volume increased 33% sequentially, thanks to the contribution of the new European credit team as well as heightened trading activity in AVS. Average daily dollar volume grew over four fold year over year due to a new talent expanded products and increased trading relationships, we now have what I would consider critical mass in five products, investment grade, high yield, European credit, ABS and emerging markets.

We are currently working to grow convertibles, loan trading and European AVS, and we will continue to selectively add to the global team. Particularly noteworthy is our efforts to grow our capital markets teams. With one of the largest distribution platforms in the industry that only made sense to leverage that strength on behalf of our issuer clients.

We established a capital market team of 10 professionals to provide capital structured advisory and transaction services, including equity in debt offerings, private placements, restricted share programs, viability management as well as equity buybacks and debt repurchases. The team is only a few months old, yet it already has a couple of client’s transactions in the pipeline. During the quarter we made 16 hires, which brought the fixed income headcount up to 161 in comparison to about 70 at the close of the acquisition in July of 2008.

Interestingly, we are witnessing the larger firms beginning to rebuild sales and trading team. Recruiting talent is now more competitive, the larger firms are also bringing their balance sheet to bear the borrowing markets. Larger firms are increasing principal trading activity to garner additional profits, there is nation activity is up as well.

Our model and contrast is agency based, we are non-conflicted because our sole focus is our client, not some internal trading book as is often the case of the big firms. We crossbones and compete on providing in depth fundamental research, deploying a large sales and trading team and maintaining great client relationships.

On the retail side, Knight’s 1.6 income you see enter broker dealers benefited from macro market conditions and continued to add new clients. Average daily trade volume during the quarter was up 126% in comparison to the third quarter of 2008. Year-to-date through the third quarter we added 79 clients, which is three times the number we added in the third quarter of 2008. Revenues during the quarter were significantly ahead of results for last year’s third quarter as our scale increased.

Now I will turn the call over to Steve for a more detailed financial review of the third quarter, I will return later with some closing comments and after that we will be available to answer questions, Steve.

Steve Bisgay

Thank you TJ, good morning. Let me begin by briefly recapping our overall third quarter performance, on a consolidated basis, Knight’s earnings were $29.2 million or $0.31 cents per diluted share. The consolidated result in the third quarter include earnings of $30.5 million from continuing operations, or $0.32 per diluted share and a loss of $1.3 million from discontinued operations or a loss of the $0.01 per diluted shares.

Turning first to our continuing operations, we reported pre-tax earnings of $49.8 million, which consist of $58.5 million of earnings from global markets and a loss of $8.8 million from our corporate segment. Global markets we generated revenues of $295.2 million during the third quarter, down 5% from the second quarter, and up 18% from the third quarter of 2008.

Global markets achieved pretax earnings of $58.5 million during the third quarter, compared to pretax earnings of $79.8 million excluding a $13.1 million lease loss benefit in the second quarter, and $88.3 million in third quarter of 2008. Global markets’ performance was driven by accommodation of factors including the profile of order flow, the shift in our business mix and ongoing investments in our products, geographies and infrastructure.

The profile of our market making order flow was significantly impacted by a decrease in volatility, heightened competition from investment banks and other alternative liquidity providers and a high concentration in low priced stocks.

Given these market conditions and our goal of aggressively defending our market share through ongoing investments and price improvement and execution quality, we experienced a decrease in our revenue capture and greater margin pressure. In the institutional equities business we experienced the return to summer seasonality with lower volumes, while in our institutional fixed income business tighter credits expressed in the US decreased software potential, yet this was more than offset by the growth in volumes in the quarter.

Again this backdrop of the market environment, our business mix continued to shift, with an increased contribution from our voice related products and services. Global markets voice products and services primarily consist of institutional equity and fixed income sales and trading efforts. In the aggregate, these voice businesses contributed $165 million in revenues or 56% of the total global markets revenues in the third quarter.

As compared to $162 million or 52% of total global markets revenues in the second quarter. Driving the shift is the growth from our newer products, such as institutional fixed income and our institutional ETF offering, which contributed a combined 26% of our global markets revenues during the quarter as compared to 19% in the second quarter.

On a combined basis, our voice businesses had a pretax margin of 17%, which compares to 21% in the second quarter. The margin compression is primarily due to the higher compensation margins in these newer businesses. In the aggregate our electronic products and services accounted for revenues of approximately $130 million or 44% of our third quarter global markets revenues, down from $148 million or 48% of second quarter global markets revenue.

The decrease in revenues in the third quarter was driven by the relative underperformance of our quantitative trading models primarily due to the profile over order flow offsetting part by volume growth within our institutional agency products such Knight Direct and Hotspot.

Pretax margins for electronic products and services were 26% for the third quarter, lower than the 35% margins experienced in the second quarter. The margin compression was primarily result of increased dollar and trade volumes relative to revenue capture, and the high concentration in volume and lower price stocks does not only impacts our profit potential on the trades, but the higher share volumes also significantly increased our transactions costs.

The acquisitions we made over the past few years continue to increase their contribution to our global markets results. During this quarter these acquisitions generated combined revenues of $96.3 million, which represents approximately 33% of global markets revenues for the period as compared to $84 million in the second quarter.

On a GAAP basis, these acquisitions had a combined pretax margin of 21%, which is up from the 18% pretax margins for these businesses in 2008, excluding non-cash related deal cost these businesses had a combined pretax margin of 24% in the third quarter.

The other primary driver of our global markets results relates to our ongoing investments in our infrastructure and businesses across products and geographies. In the third quarter we invested approximately $10.7 million on a pretax basis or approximately $0.07 per diluted share. In our international expansion efforts the development of new products such as options market making and our infrastructure such as, our move to self-clearing.

The change in the profile by order flow, shift in our business mix and ongoing investments for the future play significant pressure on our margins during the quarter. Pretax margins for global markets were 28% during the third quarter, down from 26% in the second quarter excluding the lease loss benefit.

Now let’s discuss our corporate segment, which includes the returns from our strategic investments and our corporate overhead expenses. For the third quarter, our corporate segment had a pretax loss of $8.8 million compared to a loss of $12 million in the second quarter and a loss of $18.8 million in the third quarter of 2008.

This improvement in the current period compared to the second quarter is attributable to the increase in revenues from our remaining corporate investment in the Deephaven funds, as well as a decrease in corporate overhead expenses. The P&L impact of our corporate investment and the Deephaven funds was a pretax gain of $1.1 million, compared to a pretax gain of $900,000 in the second quarter and a pretax loss of $8.5 million in the third quarter of 2008.

The average balance of our corporate investment in the Deephaven funds was $22.4 million during the third quarter, down from $27.8 million in the second quarter and down from $68.7 million in the third quarter of 2008. The decrease in our average balance is a result of the losses incurred over the past year and the distribution of $28.5 million of our investment this year, as the funds are in the process of being liquidated.

On September 30th, our corporate balance in the Deephaven funds was $16.8 million in connection with the start transaction we have elected to reduce our remaining fund balances to cash, which is expected to occur over the next 12 months.

Now let’s discuss our overall expense trends from continuing operations on a consolidated basis. Pretax margins from continuing operations were 17% in the third quarter. As mentioned previously, the sequential and year-over-year decrease in pretax margins were primarily due to a change in the profile over equity order flow, higher share volumes and transaction related costs, increased headcount and ongoing international and domestic investments.

In the third quarter compensation expense represented 46% of revenues compared to 43% of revenues in the second quarter, and up from 39% of last year’s third quarter. The increase in the compensation margin compared to last year is directly attributable to increased headcount within continuing operations, which grew from 910 employees at December 31, 2008 to 1098 at the end of the third quarter.

Approximately half of the increase comes from the growth of our institutional fixed income business and the remainder relates to general infrastructure, growth and expansion.

The competition margin also increased from last year due to the business shift experienced during 2009. With our voice channel contributing a greater share of the total revenues, execution and clearance represented approximately 17% of third quarter net trading revenues and commissions, which is higher than the 14% second quarter level, and 11% in last year’s third quarter.

These costs fluctuate as a percentage of revenue due to changes in volume, product mix, execution quality, regulatory fees and operational efficiencies and scale. Again order flow representing 6% of net trading revenues and commissions for the third quarter, down slightly from 7% in the second quarter of this year and up from 4% of last year’s third quarter. These cost fluctuated as a percentage of revenues due to changes in volume and profitability.

All other expenses were $43 million in both the second and third quarters of this year, and up from an average of $39 million over the prior four quarters. This increase reflects the general growth of our infrastructure.

Next I would like to cover the details behind our discontinued operations. As previously disclosed, on March 31, 2009 Deephaven closed the sales substantially all of this assets to Stark & Roth. As Stark replaced Deephaven as investment advisor of the Deephaven funds, Deephaven exited the asset management business. Therefore, effective Q1, 2009 the asset management segment has been reported as a discontinued operation.

The asset management segment recorded a per-tax loss of $1.9 million for the quarter, which represents residual line down cost. Added to the first half of 2009 line down cost of $41.6 million, on a year-to-date basis we have incurred a total of $43.5 million related to exiting our asset management business. Though we may incur additional line down cost during the remainder of the year, we believe that substantially all of the costs are behind us.

Now to discuss our balance sheet, our financial condition remains strong and liquid. As of September 30th we have $2.8 billion in assets, 75% of which consisted of cash or assets readily convertible to into cash, principal securities owned and receivables from brokers and dealers.

Despite the increase in our growth book size to $1.7 billion at September 30th, which was driven by overall growth, we maintained an average value-at-Risk VaR of $2.4 million during the quarter, which compares to a VaR of $2.6 million dollars in the second quarter and $2.4 million in the first quarter.

We had $403 million in cash and over $200 million in excess capital. We employ limited leverage as evidenced by 0.12 debt equity ratio, resulting from a $140 million credit facility, which we drew down within the last two years.

We had shareholders equity of $1.2 billion as of September 30th, 2009. Using our average diluted shares outstanding for the third quarter of $94 million our book value is approximately $12.35 per diluted share. Finally, we have an unlevered return on tangible equity excluding discontinued operations of 19% on year-to-date basis.

Thank you now I would like to turn the call back to over TJ.

Tom Joyce

Thanks Steve. So as we review the quarter we are quite pleased with our performance given the market conditions. We grew revenues nicely, and we picked up market share. So we did see some margin compressions.

But remember that occurred because we are continuing to deliver great executions for our clients in a more competitive environment. Additionally, our revenue mix shifted due to the terrific growth of our fixed income product, and of course we continue to invest in our future.

While our spending on key initiatives, such as capital markets, self clearing, options market making, European market making, Asian expansion and others impacted our margins, these are all large opportunities for the firm, positioning Knight to enjoy the greater operational efficiencies and/or meaningful growth in revenues and we will harvest these efforts in the not too distant future, thus driving Knight to even greater success.

Now, I would like to take a moment to discuss regulation in market structure. Given the credit crisis and the resulting disruption of the global capital market, the SEC has instituted a broad review of market structure issues. We fully support the SEC’s initiative to review the broad range of market developments which have helped shaped our equity markets in the recent years.

Competition and innovation have resulted in dramatic improvements in market technologies and execution quality for the benefit of public investors large and small.

The US equity markets are the most liquid and efficient in the entire world, and have performed exceedingly well over the last several years embracing benefits of competition and computing advances. In fact, I believe Morris Law is in effect. We have seen exponentially faster trading in greater capacity which I expect to continue in accordance with that principle for years.

It is clear that innovation in our industry in terms of automation, speed, new trading strategies and more, has resulted in a robust market for all players. From an execution quality perspective, we believe there has never been a better time to be an investor in US equities.

The advantages are considerable, including speed and stability, price improvement and a significant reduction in transaction cost. The empirical and statistical evidence is available, under SEC Rule 605 shows tremendous investor benefits under the current trading and regulatory market structure.

We are confident that the SEC would be careful and soft on its work, and not be swayed by any market participant’s self interest. We urge the SEC to look closely as a statistical evidence of how efficiently the equity markets currently operate, to assess how much value the current system brings to all investors and to ensure that any rule-making withstand a rigorous cost benefit analysis.

So, with that I would like to open up the line to question.

Question-And-Answer Session


(Operator Instructions) Your first question comes from Rich Repetto - Sandler O’Neill.

Rich Repetto - Sandler O’Neill

I guess first question is on the market share, competition in revenue capture. You mentioned the pick up in competition, the revenue path could drop to 1.2, and I’m just trying to, given all the competition is 1.2 a better number than the 1.5, 1.6 you have run at for the last year or so?

Tom Joyce

I think, as anybody who have listened to me in the last couple of years knows, I’ve been guiding people to lower revenue capturing numbers for a long time. Again, we don’t spend a whole lot of time focusing on revenue capture, but I think one of our more recent stated ranges was something like 0.9 to 1.2 or 1.3. So, we have been stating that for a while.

Of course the other thing we always talk about is volume volatility and with volatility drifting already was a natural course of events to see revenue capture come in a little bit. We feel quite good obviously about our position in the market and our ability to continue to maintain the market share. So, I’m not going to guide people of 1.5, 1.6 having done that in a long time, so I feel comfortable at these levels, so I guess the answer is yes.

Rich Repetto - Sandler O’Neill

Okay, and then you spend a fair amount of time, Tom on regulatory issues, and this thing on the dark pool with the SEC meeting today. I know there is a difference between Knight Link, which is not an ATS, and Knight Match and I guess (1) could you just sort of give us the approximate exposure or volume between Knight Link and Knight Match, and then the other part of this is, we looked at what the SEC is looking at and they are looking at actionable indications of interest as well, amending rules would that apply to Knight Link?

Tom Joyce

Yes, sure. IOI is determined by the Knight Link would apply to it. I don’t think it would change a whole lot of things frankly. Any change in the rules would of course apply to what we do, but we don’t see that it would change any behavior, at least not much behavior.

Knight Link currently is doing some between 175 and 200 million shares a day. It’s a very robust product and continues to be so. It is not, as you pointed out, it is not a dark pool it’s merely, as I mentioned earlier an extension of our market making business.

Knight Match is in fact an ATS. The Knight Match matches somewhere in the neighborhood of 50 million shares a day, up nicely over the last several months, continue to be a great tool for both broker dealers and institutional investors alike. So we expect that to grow, but our dark pool, if you will, Knight Match, is a relatively modest 50 million shares a day.

Rich Repetto - Sandler O’Neill

Then very last question, I guess for Steve, the investment spending at $0.07 for the numbers in issue, and I heard you say self-clearing as well Tom, but just going forward, what might we use, say either in 4Q or next year for typical investment spending?

Steve Bisgay

I would suggest Rich that that $10.5- $11million is a recurring run rate, certainly for the near future.


Your next question comes from Rob Rutschow - CLSA.

Rob Rutschow – CLSA

I guess along the lines of the last question, as I think about the business the pre tax margins are down sequentially and year-over-year, so I’m wondering if you can give us some guidance on the profitability of the businesses you are expanding into versus sort of the legacy businesses from a year or two ago.

Steve Bisgay

Sure. I don’t want to get crazy granular, and drive everybody away from the call, but if you look at for example self-clearing we retired 50 people probably at a run rate of $6-47 million bucks. We have an environment right now where of course we are double dipping, and I don’t mean that in the positive sense, we are double dipping on the expense side, because we are building out self clearing and of course we are still paying Merrill Lynch to clear our Bank of America to clear our trades.

I don’t want to sound crazy, a little bit of the worse of both worlds and then we have expenses coming out from both sides as we develop a very important issue, but at the same time we are using the old infrastructure.

Self clearing we strongly suspect, would save us in excess of $20 million a year, yet that would fall directly to the bottom line. So there is an example, that’s an expense savings, but it certainly is a dramatic impact on results.

Options market making, European market making, we certainly expect them to be businesses with margin well in excess of 20%. We hope they start to move the needle at some point in 2010. Should they get to $50 million each, $50 million a year in revenues each? Yes, it won’t be in 2010 but we think they can do that and more. We certainly know how much our equity market making business makes in the US and we think the opportunity in options and European equity market making are very impressive. So we are very enthusiastic about that.

Capital markets business, God bless them, they already had two mandates and they are in the market already and the team is barely three months old. They are pitching issues with everyday. That I think is another 50 million plus opportunity, again not 2010 perhaps but we are getting there, and Asia is huge. Asia, obviously we are loosing a lot of money now as we invest in it, but you tell me what the opportunities in Asia.

So we are talking about tens of millions, over a $100 million of impact over the investments we are making right now over the next couple of years. So we are very enthusiastic about where this is going, not withstanding the fact that there is a little short term slippage in margins because of our investments.

Rob Rutschow - CLSA

I guess not to get too granular, but can you talk about the payouts for fixed income versus the equity in terms of your personnel?

Steve Bisgay

The payouts are a little higher in fixed income than equities, mostly because the fixed income infrastructure that we have is less cost intensive. So, a little bit more does accrue to the producers, also because the competition in that market has sort of moved the payout ratio a bit higher in the fixed incomes base.

So, yes, I’m not going to get crazy granular, I don’t want to hurt us competitively, but you are right in your assessment that the fixed income business at this time has a little bit higher comp-to-revenue ratio than the equity business.

Rob Rutschow - CLSA

Lastly, can you just give us a little bit more color in terms of the competition between the different businesses where you are seeing the most pressure on spreads and trading commissions in terms of fixed income versus equity?

Steve Bisgay

Sure. The institutional equity business s competition hasn’t really changed a whole lot, it’s still a doggy dog world out there, and commission pressure really hasn’t been asserted.

Certainly spreads have come in, in some of the segments in the fixed income business, simply because the large firms, the firms formally known as the Bulge Bracket, you apparently want to be known once again Bulge Bracket are using capital a little bit more in the trading for the counts a bit more.

So, as that sourced liquidity shows up in the market it does narrow spreads a little bit, and of course in the market making business as we have seen a few new competitors and things like [nailing] product is a scene of cover of our traditional competitors, intensify their attempts at getting market share for themselves.

We see increased pressures there and results in this a little bit less, a little bit more of the expense side. So, I would say in the order of competition, if I had to string it together I would do it in that fashion as not a lot of change institutional equities. There is the expected effort of the bigger firms which now spreads a little bit in the fixed income side, and there was a little more renewed vigor on the US equity market making side, I would probably scale them in that order.


Your next question comes from Roger Freeman - Barclays Capital.

Roger Freeman - Barclays Capital

I guess we’d just come back quickly on the dark pool issue. So, it sounds like from your perspective with Knight Match being the primary risk here and being small, it’s not a big deal for you. I guess I was a little curious. Your commentary right at the end of the call seemed to fairly adamant against it, and is that just your sort of personal view or is that as a representative of Knight?

Tom Joyce

Really adamant against what?

Roger Freeman - Barclays Capital

To make some of these changes with respect to the dark pool, reducing the percentage of volume that...

Tom Joyce

As I believe, I started that comment. We fully support the SEC’s initiative to review market structure issue, things change and need to review them. I think what I’ve tried to get across was that old thought “In God we trust” everybody else needed to bring data.

So, I am assuming the SEC will in fact look at the data that’s available and [draws] in the market that pointing out the fact that the execution quality has literally never been better for the small investor. So that the markets have literally never operated as efficiently, yes, stocks go down sometimes, sometimes they go up, but in terms of operationally it’s never been more efficient.

So our desire and what we are trying to encourage the regulators to do is use data as they make these decisions and not use and not be influenced by various throbbing efforts from some disinfected parties who have lost bottom market share over the past few years.

Roger Freeman - Barclays Capital

I guess so, let me shift topics. Can we drill down maybe into this the order profile you talked about? I think the one thing I found interesting was your comment on the alternative liquidity providers, and that’s had some impact on the spread. I haven’t heard you mention that before.

I mean are these the geckos of the world, I mean they’ve been around for a while, I was just curious what sort of change that might be impacting your algos, are they gaining you, what’s going on?

Tom Joyce

Yes. You mean the seven competitors last year, with twenty-five this year, the one I mentioned earlier, that thing?

Roger Freeman - Barclays Capital

Well, how much of that’s buy side versus other sell side oriented firms?

Tom Joyce

Well, that’s mostly sell side oriented. It’s the same profile as the other competition we are seeing. The core group of people who make markets in the US its Knight, its Citadel, and its City with their subsidiary and its UBS. We have and continue to have leading market share there, but we are certainly seeing some renewed competition coming out of that space, as well as some of the other higher frequency shops that are getting into things like alternative liquidity provision, providing and things like that.

So, we are seeing a number of firms trying to step up and compete, not surprising given the result of last year where the only firms who really thrived were the firms who were practical and unlevered in their response and they handled the equity markets in a way that was avoided age positions and were “The moving business or the storage business.” So I think people saw the results and thought gee we should try this out, and as a result we see a few more competitors.

Roger Freeman - Barclays Capital

So that looks like it’s here to stay for a bit. Then, I guess in speaking of sort of last year versus this year, I mean you mentioned the voices it sounds like it’s really on the fixed income side. Is the voice business down sequentially on equities as the larger firms are becoming and facilitating?

Tom Joyce

We have not seen any real capital facilitation on the equity side. I don’t think you really will ever see that again, like you did in the late ‘90s because it’s a negative selection game and the buy side almost always has more information than the sell side, and putting up big blocks has proven to be painful.

That’s why there have been solutions introduced to the market, things called dark pools, like liquid and a few other things that have helped solve for liquidity issues around the institutional investor. So we haven’t really seen any kind of change in the behavior of our competitors other than their adding to staff and trying to be more aggressive calling the clients.

I would say that, and point of fact as I mentioned earlier, the wallet the commissions paid out in the industry during the course of 2009 is down about 20% and we are basically flat; we are down a little bit. So my take on that is, and point of fact, we are not losing ground to competitors. We continue to pick up market share in institutional equities globally.

Roger Freeman - Barclays Capital

Just lastly, can you just maybe help us think about the maybe the productivity of employees, you have grown your employee base something close to 25% over the last year and you went through some of the pieces where we know there is really no revenue yet, but let’s say on Libertas, anything you could talk about like what percentage of the employees you think are fully productive. I mean there is a ramp up period, and then on the comp side are most of the folks coming in with guarantees for this year, any for next year? I am trying to get a sense for how fixed the cost base is right now?

Tom Joyce

Sure, you mentioned our headcount gone up of over 200 people, it has. Only put that in perspective if I could. We have probably 50 in self clearing. We probably have over a 100 in the fixed income product. We probably have 20 to 25 in Asia, we have 20 plus in the ETF product. So I just want to make sure everything is clear on this call.

We are adding the headcount, but the headcount we are adding are called producers. They are driving revenues and or making our operation dramatically more efficient in the guides of self clearing. So we feel very good about the headcount we’ve added and believe they are all going to contribute greatly over the next couple of years.

If I had to put a scale as to where they are sort of on their productivity chain, well clearly as productive as self clearing team is, they haven’t actually benefited as of yet because of our deal and our continued contract with Merrill, so that’s a year or so out.

I would say if you wanted to ask me where the 100 people are that we added or plus or minus, that we added at Libertas, I would say anybody who has been here for more than three or four months is operating pretty close to peak efficiency.

Anybody who has been here less than three months is still making relations, still extending out the new relationship paradigm to their clients and they are getting to know where the bathrooms are and things like that. So, the only amount of time before we see a lot more productivity there, and we will continue to add talent obviously as business conditions allow us.

For your third question in terms of guarantees, we really don’t give out too many guarantees. It’s rare, people tend to get guarantee draw if you will, a form of a salary that’s relatively modest and is enough to pay the mortgage I guess. So, all of the attraction continues to be the ability to drive your own income through hard work in deepening relationship with client. We really don’t have much, if any, frankly over hanging around extended long-term deals for any producers coming in, hardly any producers coming in on the fixed income side.


Your next question comes from Daniel Harris - Goldman Sachs.

Daniel Harris - Goldman Sachs

You talked a little bit about Europe and Asia that they’ve been signing up new clients, and I think that was mostly focused on Asia, but Europe as well. Can you put to me the quantitative or qualitative color around how that business is going relative to your expectations, and how you think that’s going to grow over the next 12 to 24 months?

Tom Joyce

Well, the European business is growing quite well according to our expectations. They are doing a lot of the right things over there, obviously in the equity side we have a little bit of an environment with volumes down quite a bit over there, but they are continuing to hold and gain share.

The fixed income presence in Europe has been phenomenal for lack of a more enthusiastic word. They have done a great job and continue to do a great job. So I think pretty much across the board in Europe things are at least what we hoped done better.

In Asia, yes, we probably got off to a slower start than we suspected. So I would imagine our growth pattern our growth plan over there has probably been delayed nine months or so. So we still feel pretty good about where we are. We are probably something like nine month behind schedule, but it is Asia, it’s hugely important territory and we are committed to growing it out and feel good about what the team has done.

Daniel Harris - Goldman Sachs

Is that, in the Asian business, is that larger your voice brokerage business that you are launching first?

Tom Joyce

Yes, exactly Dan, Yes.

Daniel Harris - Goldman Sachs

So, shifting gears here a little bit, I think that the Section 31 fees go down here in the third quarter. How does that impact you guys? I think its October 1 that they actually started going down. Is that going to drop your expenses and thus margin should come higher in global markets just on that alone?

Steve Bisgay

Dan, that’s actually not the case. The answer is, the Section 31 fees are not going to go into effect until the SEC appropriations goes enacted. It’s unclear right now when that bill will be in fact enacted. So, at this point we don’t expect that it’s going to occur in Q4, we are certainly not planning for that, more than likely we are thinking Q1 event and have to determine ultimately what that down tick in cost will do.

Daniel Harris - Goldman Sachs

Then just lastly, can you talk a little bit about your SLT business at the exchange and how that’s going?

Tom Joyce

That’s going fine; profile didn’t change a whole lot during the third quarters. Its okay, but it’s an interesting component of our margin making business, it’s not much of a driver of results frankly.


Your next question comes from Chris Allen - Pali Capital.

Chris Allen - Pali Capital

Just on the execution incurrence fees. The 17%,ilooking at it as percentage of revenue, that’s the highest we’ve seen in basically about two years given the Section 31 fees not rolling off potentially till next year, should we assume that the run rate is going to be at that level going forward. What exactly drove the increase in percentage of revenues?

Steve Bisgay

I think it’s a function of the profile of the order flow. As we saw in the first two quarters of this year, including the third quarter now, we are definitely seeing higher volumes, high concentration of low price flow, that volume and that dynamic puts a lot of pressure on our execution costs as well.

Chris Allen - Pali Capital

I mean just thinking about that, looking at the share volume, the real pick up it seems like it was an over the counter bulletin board and other shares, you listed and that shares were down sequentially. Is that the component you are kind of referring to, because when I think about the low priced shares there tend to be more listed?

Tom Joyce

Well, I think if you look at the ratio of low priced shares versus this year over the last, it’s probably more than doubled in this quarter. So that phenomenon still continues. Maybe some of them are not low priced any more, but some still are CIT is still a low priced stock for example.

So, that phenomenon is continuing. I think it will continue to be of that profile, due to the fact that what we are seeing in retail, what we are seeing and rest of them start to do is to be willing to assume more risk and get somewhat more speculative.

We had a monster increase in share comp in the bulletin board and things, which I always attribute to a willingness to sort of speculate if you will and with low price stocks on the exchange is people are doing similar things, except having them to be exchange rated vehicles.

So I suspect that with the retail investor picking up we are willing to take on more risk, if you will, but that profile of our order flow probably won’t change much for the foreseeable future.

Chris Allen - Pali Capital

Just shifting back to kind of the dark pool question, some of the chatters, the SEC is basically going to take action to kill the dealer-owned dark pools with the threshold level dropping to 25 bibs. It seems like a pretty much a worst case scenario, what would be financial impact if basically Knight Match was almost forced to shut down?

Tom Joyce

Well, in terms of getting on sop-park it would be really too bad if they kill competition, it would be a dreadful thing for the markets in general if they start to impair competition in the market.

Having said that, I don’t know it would be like $2 million bucks a year or something like that. Mostly some revenue and some expense savings because Knight Match is really efficient, so it allows us to avoid going to the exchanges and paying transaction cost sometimes. So it would probably be a couple of million bucks a year, if Knight Match had to be withdrawn from the market.


Your last question comes from Ken Worthington - JP Morgan.

Ken Worthington - JP Morgan

Two questions, one is a follow-up on Rob’s question earlier. I think your goal is maybe $3 of EPS over the next two to three years and you mentioned, options market making, European equity market making capital markets is kind of some big initiatives. Are there any other big holes you can fill in to get us between where you are today and what needs to happen over the next two or so years to get to three bucks of EPS?

Steve Bisgay

Sure. I’d be happy to talk about that. As you know this summer, at the family conference I did make a statement that our goal is $3 in three years, which from 2009 of course is 2012, and of course I want to reiterate once again it’s not guidance, but it’s a goal.

But having said that we have three legs of the stool here that are all operating pretty well and they all are positioned to grow. So, we fully expect to see growth in the institutional equity business. We have all kinds of opportunities globally. We still have a lot of room to pick up share in the US.

We fully expect new products like our ETF team and potentially others that are in the pipeline that will definitely add to our positioning in institution equity, and of course we’ve seen a crazy amount of growth in our Knight Direct products. So we have opportunities on the voice side and the electronic side that will drive results in the institutional equity team over the next couple of years.

The Institutional fixed income team. We have increased our dollar volume traded over four fold in a year. Now, we don’t expect to continue to do that again, but we certainly expect it to grow rapidly. We have at least five products that are well past critical math and are positioned to grow domestically and globally.

Our market share in fixed income, I don’t know it’s a low single digit number right now. We have a lot of room to grow in fixed income, and especially when you add things like the capital markets team, which has gotten out of the blocks extremely fast.

So we think that business could grow a ton in the next three years, and of course the brokerage dealer business, the electronic trading market making opportunities that we have continue to be in the US, we know there’s been some more competition, but we have 75 folks in the electronic trading group who are constantly coming up with new models, innovating with new products.

So we believe that our ETG team will pick up share and I should say broaden its impact in the US and it’s only starting to do things around the options market making and European market making. So I feel very good about our goal of three bucks in three years.

Ken Worthington - JP Morgan

Then may be flushing out Rich’s question on IOIs, hopefully this is not too dangerous to do on this call. But can you just talk about how you think regulators may alter the use of IOIs in the future, what is may be a likely outcome of their probing their, if any. Then which of Knight’s businesses are really dependant on IOIs. Is it really just Knight Link or are there other businesses that IOIs are a key component of the value ad and how scared should we be about IOI regulation with regard to Knight.

Steve Bisgay

We think the core thing in IOI is; is it an IOI? An Indication of Interest or is it an order, and, they are going to do I think whatever they see fit in terms of making sure that orders are not being masqueraded as IOI. If that happens, we won’t be changing our behavior too dramatically here, because we got it and we understand how well Knight Link and the other market making products work.

So, if they move the needle a little bit we feel pretty good about the way they operate now, so if we have to make adjustments we will. So we feel quite confident that the product will still be an important one that really helps our client save a lot of money.

So, if the IOI debate intensifies really fundamentally that what you have seen is a move to make sure that an order is an order and an IOI is an IOI, and that seems fine to me. I think as long as the SEC is using data, which they have always in the past, then we feel very good about what the outcome is likely to be with the regulatory oversight that’s coming our way.

Clearly we have innovated on a lot of fronts over the last few years, and I think some of the innovations that are gone in the market place. They just want to take a step back and look at it and make sure it’s having the beneficial effect that we all believe it has. So, regulatory changes is constant in our business, we think the SEC has done a fantastic job monitoring the transactional businesses in the past few years.

Now, let’s face it. There is a bit of a cloud over the SEC, but if you will it’s a made light cloud. What’s the job they have done on the transactional side has been pure and as evidenced by the fact that the US equity markets are arguably the best markets in the world. So they continue to bring the approach they had brought in the past encouraging transparent competition with decisions dictated by data and not political influence. I think we are going to be in great shape going forward and the markets will arguably be healthier.

Ken Worthington - JP Morgan

Okay. So, not a needle mover for you, the debate on IOI

Steve Bisgay

No, I don’t see at this point. We are watching it closely and we think that any kind of clarity on IOIs versus orders will be fine, and we will be in a position to make it work.

Tom Joyce

Well, thank you all for your questions and I just want to say thank you to our clients for their loyalty and our employees for their incredible hard work. There is a great deal of opportunity in front of us, and I am very confident that we will continue to deliver for our shareholders. Of course I look forward to seeing many of you at our analyst day on November 2. Thank you all very much and have a wonderful day.


Thank you, ladies and gentlemen. Once again that does conclude today’s conference. We thank you for your participation.

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