DREAMY RIDE OF NASDAQ MARKET MAKER IS QUICKLY TURNING INTO A KNIGHT-MARE: PLUMMETING SHARES RATED ‘UNDERPERFORM’

Knight/Trimark Group Inc.’s not getting the royal treatment anymore.

Even before the bull market started to trip in late summer, shares of the largest market maker for Nasdaq stocks had already tumbled.

Investors have sent shares down from a high of $78 in May to around $25 early last week. Analysts are taking their stabs, too. Institutional brokerage Sanford A. Bernstein gives an “underperform” rating to the Jersey City, N.J., firm — Street jargon for sell, sell, sell.

In September, Knight was the seventh most heavily shorted stock in the midcap market, according to Michael Long at Rockridge Partners. While many people haven’t heard of Knight, nearly everyone knows the trend from which the company benefits — the rise of Internet trading. Such online brokers as E*Trade Group Inc. and Ameritrade Holding Corp. hire Knight to execute their orders.

As more and more individuals started trading shares by clicking their mouse rather than calling their broker, Knight’s volume in the first half of this year rose to 18% of all Nasdaq trades.

Recently, though, online brokerages, which account for nearly 50% of Knight’s orders, have seen their trading volumes slip.

Internet brokerage trades fell by as much as 10% in the third quarter, according to Greg Smith, an analyst with Hambrecht & Quist in San Francisco. And that’s caused Knight’s earnings to come in short of analysts’ expectations.

In the third quarter, Knight had earnings of $21.8 million, or 13 cents a share. While the firm’s per-share income was up 46% from a year ago, it was also less than half the 30 cents a share analysts had been expecting only a month earlier, and less than what the company earned in both the first and second quarters of this year.

“Our growth rate bulge-out in the beginning of this year wasn’t sustainable,” says Kenneth Pasternak, chief executive of Knight.

REVENUES IN QUESTION

Declining volume was only part of the problem. Knight’s average revenue per trade plummeted to $6.33, from $10.09 in the second quarter and $8.52 for all of last year — and a number of analysts think it’s only going to get worse.

“Their ability to sustain revenues in a normal trading environment remains a question,” says Sean Chin, an analyst with Merrill Lynch & Co.

Knight, which was founded four years ago by a consortium of online brokerages, makes a much larger profit trading small-cap stocks.

So as long as investors want to trade those stocks, as they did in the beginning of 1999, Knight’s business strategy works like a charm.

But starting in the third quarter, online investors began favoring stocks like Dell Computer Corp., creating problems for Knight. The company’s profit margin on trading such large-capitalization stocks is close to nothing.

“For the 100 most liquid stocks, most of our business is simply matching trades, and we consider that a loss leader,” says Knight’s Mr. Pasternak.

Knight’s profits could erode even further when Nasdaq moves to a decimal pricing system, which it plans to do next year.

That threatens to narrow spreads — the difference between the prices at which Knight buys and sells shares — even more than they’ve already tightened.

NEW TRADING SYSTEM

Mr. Chin, who recently downgraded the company’s shares to “neutral,” thinks that could further crimp Knight’s profit margins.

What’s worse, some of the volume in larger stocks is moving to a new type of trading system. These rapidly growing electronic trading networks allow buyers and sellers to match trades directly, without the need for market makers.

Island ECN, one of the largest of these trading networks, says it now handles one in every four Yahoo! shares that are traded.

Of course, there will always be a need for market makers like Knight that will provide liquidity in small stocks and guarantee trades.

“Clearly there’s a place for them,” says Matthew Andresen, president of Island ECN. “But in trading Dell, they are not going to add much value.”

Crain News Service