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Knight Trimark and the Online Revolution
07-Oct-99 01:07 ET
(BRIEFING.COM - Robert V. Green) A very common cartoon image is that of the little fish being eaten by a big fish, which is turn, being eaten by an even bigger fish. Knight Trimark is the fish in the middle, according to a fascinating research report issued by Sanford Bernstein analyst Steve Galbraith yesterday. After grabbing a huge market share of Nasdaq volume, it now faces the very same type of threat it used to build itself: cheaper, faster execution. The next fish on Knight Trimark's tail? ECNs.
Knight Trimark (NITE)
Knight Trimark is a fantastic business. Created just 5 years ago, it now controls 20% of all Nasdaq trades, and 7% of NYSE trades. Historical revenue growth has been 100% year-over-year, with 30%+ operating margins, and 50%+ return on equity.
Knight was started by E*Trade, Discover, Ameritrade, and Waterhouse Securities as a joint venture. These firms route trades to Knight Trimark for execution, and the boom in retail online trading is the principal reason for Knight Trimark's unbelievable growth rates and operating margins.
Knight's competitive advantage, initially, was simply, lower costs, and routed order flows from the major online brokerages. NITE is now the largest market maker on the Nasdaq.
It is not surprising that Knight Trimark was one of the hottest IPOs in 1999. It seemed like a direct play on the growth of retail online investing. With so many orders being routed to a single market maker, how could the company fail? Isn't retail investing simply going to continue to grow?
The Future of Trading
The answer is yes, online investing will continue to grow, but the change in how transactions occur is likely to have a greater effect on trading.
The essence of the argument made by Sanford Bernstein analyst Steve Galbraith is simple: the extremely lower costs (1/30 the cost of a Knight Trimark transaction) and anonymous nature of an electronic communications network (ECN) will drive volume to ECNs in record numbers.
Currently, when you place an order at an online, or traditional broker, the order is passed to a market maker in the stock. That market maker maintains a BID and an ASK for the stock and either matches a SELL to a BUY, capturing the spread, or absorbs shares until a buyer/seller can be found. A market maker risks their own capital to maintain orderly markets.
But an ECN matches orders solely by computer. Where a transaction takes 22 seconds from start to finish on the NYSE, an ECN transaction is barely measurable.
ECNs do not provide capital to make markets, but if there is enough volume, the markets make themselves. This is a huge risk, if volume ever dries up. However, the crash of 1987 showed that the mere existence of capitalized market makers doesn't always mean liquidity either.
Sanford Bernstein estimates that the ECNs, primarily Archipelago, Island, and Redi, will eventually capture 50% of all Nasdaq trades and 25% of NYSE listed stocks, unless some new Nasdaq or NYSE reactive action is taken.
The principal advantage ECNs have is a completely leveraged business model, with very little capital requirements. Mr. Galbraith describes the Island ECN as trading 100 million shares a day on "a couple of Dell computers and about 20 employees in an office in lower Manhattan that houses cockroaches the size of small dogs." Not your typical Wall Street image.
What It Means For Knight Trimark
The future is complex. Knight Trimark is currently gaining market share, and growing both revenues and earnings, as it steals orders from traditional brokers.
But right on its heels is the advent of ECNs, threatening to change the face of the markets.
Just five years old, and already threatened by the very same forces which gave it birth: lower cost, greater volume. There is a great business lesson here.
Briefing.com Conclusion
There is also a great investment lesson.
Valuations based on the past are only relevant if the same forces can be expected to continue. When a company with a short, but incredible growth curve, suddenly has destructive forces on its heels, the past means nothing.
The analysis by Sanford Bernstein analyst Steve Galbraith is right on the money. In effect, what Knight Trimark did to the existing market maker execution infrastructure, ECN's will do to it. And there is little that Knight can do about it, at the moment.
But even more amazingly, Knight Trimark will continue to steal market share from the existing, traditional market makers, who will suffer even more than Knight. What this means is that Knight will become an even stronger player in their current marketplace (than they are now), but because their margins will become slimmer, their business results will suffer. Mr. Galbraith expects Knight's return on equity to be halved, from its current 60% to 30%.
If Mr. Galbraith is right, and his argument is persuasive, it would have long term serious consequences for Knight Trimark's business results. Even though absolute revenues, and earnings, would still be growing, it is all from increased volume. The compression of margins would remove a great deal of the leverage in the model. Once this becomes apparent, Knight's already damaged multiples would likely suffer even more.
Here you have a powerful company, whose market share, revenues, and total earnings, are all increasing, yet their stock price is in danger. Even though Knight did a lot to collapse existing price structures, it can't prevent the next wave, ECNs, from collapsing its own margins.
The online revolution still has a long way to go. |
