Knight Trading Eyes Expense Side

Updated from 12:35 p.m. EDT

The largest market-maker in Nasdaq securities,

Knight Trading

(NITE)

, reported a 10-cent loss for the first quarter, due to calmer markets, new regulatory changes and losses at its European operations.

The loss, which included a 3-cent charge, was at the high end of its own lowered forecast. At the beginning of April, Knight warned it would post a loss of between 10 cents and 12 cents a share in the first quarter, rather than the profit of 10 cents a share analysts were expecting. The company earned 21 cents a share a year ago. Revenue fell to $133.5 million, down 41% from the year-ago quarter's $225.6 million.

The first-quarter charge comprised $6.1 million for impaired investments in an e-commerce company and another investment, $425,000 for a writedown of options exchange seats, and $600,000 in charges to discontinue its options market-making activities in London and Australia in the first quarter.

Knight set plans to cut costs by an additional $30 million before the end of the third quarter, as it doesn't expect any material pickup in trading activity anytime soon. The cost-cutting will cover most areas of its business, including capital spending, infrastructure, management and client services, both abroad and domestically, management said. Knight is also looking to cut variable expenses, such as payment for order flow to some customers.

Last year, Knight cut $30 million in fixed expenses to leave total spending at $155 million in the first quarter. Even so, the company still has extra fat. Knight bulked up its business to handle the surge in trading activity in 1999 and 2000. But when the Nasdaq tumbled, trading volume and volatility also dropped, and the implementation of decimalization last April dramatically reduced Knight's revenue per trade.

More Than Cost-Cutting

Analysts said they were reviewing their earnings estimates for 2002 and 2003 following the announcement, but they don't seem to be sure cost-cutting alone will get the company back to profitability. Knight needs to eliminate losses in Europe and decrease payments for order flow in its options business, observers said, while trading volume and volatility need to return.

One analyst, who didn't want his name used, said he didn't expect to make major changes in his earnings estimates for this year. "The question I have is, is this international restructuring going to eliminate losses from the international side in the third quarter," he said. "Even if that happens, we still need a bounce in market volumes and volatility to jump-start the company back to profitability."

Knight earned 11 cents in the fourth quarter of 2001 when trading activity and volatility rose. But both fell again in the first quarter, and the summer tends to be weak. Knight's shares, which have plunged more than 50% since the beginning of the year, closed up 6 cents to $6.62.

Knight said its domestic equities business was profitable in the first quarter, but that it plans to cut costs in this segment anyway in order to hedge against a protracted market-making slump.

Continental Drift

The company doesn't yet plan to exit its unprofitable European business, despite an uncertain timetable for a recovery of the continent's markets. Knight is planning to eliminate jobs in Europe, but it wants to maintain enough of a presence to take advantage of a turnaround. The company has calculated, however, that closing up shop there would result in an after-tax charge of 20 cents a share.

Analysts are hoping Knight will make the deepest cuts to its European operations, which accounted for more than half of the company's operating loss in the first quarter.

On a conference call, Knight said it's devising a strategy to minimize losses in Europe by the end of the year. Cutbacks may be dramatic, but Knight isn't planning on ditching the effort altogether, at least not yet. The company said that it would take a maximum after-tax charge of 15 cents a share in the second quarter to scale back Europe. That's just 5 cents shy of the total estimated charge to shut the operation entirely.

"While Knight has cut in half quarterly losses in Europe since the middle of 2001, there is more work to do," the company wrote in a statement. "We will conclude our evaluation of our London-based operations in the second quarter and determine the appropriate changes in order to minimize losses by the end of the year."

They Have Some Options

Knight's U.S. options business also needs work, according to Merrill Lynch analyst Shawn Chin, who recommends the company reduce the payments to customers for order flow. "The economics are deteriorating," he said. "Because of deteriorating revenue capture trends, Knight generated $2.40 per options contract in the first quarter. But it's paying as much as $1 per contract in order flow, and that's before expenses." Chin emphasized that the company may not pay $1 for all contracts. Knight has already gotten rid of its options offices in London and Australia.

The company's options market-making activities generated total net trading revenue of $27.2 million in the first quarter, down from $41.6 million in the same period a year ago. The asset management business brought in $7.1 million in fees, down 44% from $12.7 million in the year-ago quarter.

Cost-cutting aside, Knight hopes to boost revenue growth by wooing more institutional traders, who accounted for 38% of total trading revenue in the first quarter, and by exacting payment from online retail traders, rather than paying them for order flow. Some analysts, though, believe those goals could be tough to meet.

"For the sophisticated active investors, there may be some that would pay for

Knight's liquidity," said Chin. "On the other hand, if you're looking at the mainstream online investor, they're already paying brokerage commissions. I'm not sure they would pay additional cash."

Chin said the company also has a lot of competition for institutional customers from both ECNs and Wall Street brokerages. Institutional clients "do have the option of going with a value-added market maker that can provide research and access to IPOs," Chin said. "Or they have the choice of going through an ECN and preserving their anonymity. They only stand a chance if there is a pickup in trading activity in less liquid names, like the smaller cap names."