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Editorials, Monday, 03/20/2000

Market Power
By S.P. Brown

Point, click and trade. Everyday, more investors are developing the skills to take financial matters into their own hands. According to recent projections published by Merrill Lynch (MER), online investing accounts will double to 30 million over the next two years.

With that kind of growth, a lot of money is obviously flowing into the online trading industry. However, just because money is flowing in, that doesn't necessarily mean money is being made. In fact, the likes of Ameritrade (AMTD), E*Trade (EGRP) and DLJDirect (DIR) have had a stubbornly difficult time turning a buck.

It's a classic case of Internet "front-end-it" - that all-to- common inability to make money in B2C e-commerce. Like most industries that have taken to cyberspace, the brokerage industry has found that the real money is being made by those companies that have taken a step back from the retail customer.

No other company in this industry exemplifies the importance of staying in the shadows more than Knight-Trimark (NITE), the largest market-maker for the Nasdaq and over-the-counter (OTC) stock markets.

Knight-Trimark handles more than 21 percent of all the trades made on Nasdaq and OTC companies. What's more, the company handles approximately 8 percent of the market for listed securities, making it the third largest market maker for these auctioned securities after Merrill Lynch and Citigroup (C).

Knight/Trimark makes its money by matching broker's orders for OTC and exchange-listed stock, which essentially makes the company a broker's broker. Principal customers include volume giants TD Waterhouse (TWE), Merrill Lynch, E*TRADE, and Ameritrade.

For each trade, Knight-Trimark charges a spread, the difference between the bid and ask price, with the general rule being that the more illiquid the security, the larger the spread. As Knight-Trimark deals largely in smaller securities, these spreads can be quite significant.

However, Knight-Trimark not only makes money on the bid-ask spread, it also makes money trading for its own account. The company is able to do this because of the proprietary information it gleans by being a market-maker. Market-makers are able to take information about retail customers' trading intentions and use that information to improve their own proprietary trading record.

And, no, this isn't some covert form of insider trading. Specialists on the NYSE and AMEX also have this advantage. It's a method for compensating market-makers for accepting the risk of providing a liquid market for a specific security.

To get an idea of just how proficient Knight-Trimark has become at trading for its own account, the company hasn't had a single losing day so far this year.

In fact, Knight-Trimark has become so proficient at market- making and trading, its financial statements could easily impress the most jaded number-cruncher. For fiscal year 1999, revenues more than doubled to $801 million from the $356 million posted in 1998.

Unlike many Internet companies, Knight-Trimark doesn't book revenues for the sake of growth. This company makes money. Net income more than doubled to $168 million in 1999, up from $67 million in 1998 - all while maintaining a balance sheet as pristine as an early morning snow. Knight-Trimark has no long- term debt, $303 million in cash and 49 percent return on equity.

Going forward, there appear to be few obstacles to impede Knight-Trimark's exponential growth. In fact, Merrill Lynch has issued a report stating the company could easily increase its market share in Nasdaq/OTC volumes to 30 percent over the next two years.

What's more, the company is looking to reprise its success in the US equities markets in options. The firm currently holds seats on the CBOE, AMEX and Philadelphia Stock Exchange. Knight-Trimark believes it can capture 5 to 7 percent of the options trading flows over the next two years. According to management, each 1 percent gain in market share could translate to $20 to $30 million in earnings for the firm.

Foreign equity markets could also hold promise for Knight- Trimark. In Japan, the company is negotiating a market-making joint effort with Nikko Securities. In Europe, Knight-Trimark is in the process of forming a consortium with 15 to 25 online brokers to clear trades the way it does for many online US brokers.

Despite all this growth potential and proven money making ability, Knight-Trimark is currently trading at a 41 percent discount from its 52-week high of $81.63.

This is something of a head-scratcher, for few analysts have turned negative on the company. Last week, ABN AMRO raised its earnings-per-share (EPS) estimate on Knight-Trimark from $2.20 to $2.60 for 2000, and issued a price target of $65 per share. Moreover, ABN projects Knight-Trimark will trade 45.5 billion shares this quarter, up 75 percent from the previous quarter.

For its part, Merrill Lynch has raised its 2000 EPS estimates from $1.90 to $2.25 based on stronger first-quarter market share assumptions.

Robertson Stephens likes what it sees for the entire industry. The investment advisory firm recently issued a positive report on the online brokerage industry and raised its sequential transaction growth estimates for the March quarter.

According to the report, share trading volume in the March quarter will likely be the strongest ever, with an average weekly volume of 8.6 billion, a 36.6 percent increase from last quarter. In addition, it's raising its online brokerage growth for the quarter to 35 to 40 percent, from 25 to 30 percent.

At its current price of $48.50 a share, Knight-Trimark makes a compelling investment. The company is by far the largest player in a fast growing market-making business for Nasdaq stocks, yet trades at a current price-to-earnings (P/E) ratio of 35, even though it's expected to grow earnings at a 47 percent annual rate over the next two years.

 


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