KNIGHT > 2002 Annual Report, Discussion with CEO


	Knight is at a particularly fascinating point in its history. So much is going on here internally, so many exciting prospects. At the same time, external pressures have never been more intense. You can see the effect of these pressures on our 2002 results, our first annual loss. Revenues fell to $527.4 million from $684.7 million in 2001, with Asset Management as our most profitable segment. Pre-tax income reversed from $54.3 million in 2001 to a loss of $73.8 million in 2002. Knight lost $43.2 million in 2002 compared to $38.5 million in net income in 2001. Earnings per share for the full year was ($0.36). You might also say that Knight is at an important crossroads, between what it was and what it can be. That’s why I think Knight will be a dynamic company to track as we enter 2003. We have a full agenda that includes efforts to improve our reputation in the marketplace, shift our organizational structure to focus on clients, and adjust our model to grow our institutional business while maximizing the potential of our original broker-dealer business. All to move Knight along what we call the pathway to profitability. But before I get too far ahead, let me briefly explain why I came here in the first place. Knight was a company I had watched with admiration since its founding in 1995. It started as a concept that quickly grew into one of Wall Street’s most important firms. Later I watched as Knight wrestled with dramatic changes in market structure and the increasingly difficult market environment. In 2002, I came to Knight because I enjoy challenges and believe in the potential of this company. Knight’s business model is strained, but the trading platform is unparalleled. I was and I am very proud to have been selected by your Board as Knight’s CEO and President. But I also knew I had my work cut out for me. That the company would face difficulties so soon into my tenure was not, however, something I would have anticipated. ESTABLISHING OUR REPUTATION AND BRAND My official first day of work was May 30, 2002. Within a week, it was clear my “honeymoon period” was over. On June 3, a software glitch in Knight’s trading system generated a series of sell limit orders in our stock, disrupting trading and adversely affecting the quoted price of Knight’s stock. While the event was isolated and had no bearing on our business, clients were understandably concerned. This event was followed the very next day by media coverage of what was supposed to be a private arbitration claim in which a former employee made allegations about the way Knight handled trading for some of its clients. I believe the allegations in the arbitration claim were unfounded, but the stories and resulting inquiry by regulators damaged Knight’s reputation. This brings me to the first initiative I’d like to discuss. It’s actually a summary of multiple efforts to shift the perception of Knight, a perception that has been driven by the negative events of the last year as well as by Knight’s rapid rise to success. Over the last nine months, I have to come to understand that establishing or changing a reputation among external constituents is in fact reliant on changing a corporation on the inside. Corporate reputation is tied to both how we do business, and how our employees understand our business. First, we tackled our organizational structure. We stepped back and looked at Knight from a client’s perspective. What we saw were multiple subsidiaries that meant different things to different people. Our regulated entities still exist, of course, but overall the organization is being simplified to revolve around clients rather than the individual subsidiaries themselves. We’re instituting greater coordination among our product lines as well as between our two primary client groups, broker-dealers and institutions. More teams are being formed around clients rather than teams designed to sell one specific product or service. The renewed client focus also is driving the creation of new and enhanced offerings that are either homegrown or obtained from the outside. Employees are embracing this new client-centric structure and the mindset of one company. With one approach. And one brand. It’s just the beginning of building a new corporate culture. In 2002, we also aligned compensation so our market makers are rewarded for providing the best possible service to our clients. In 2003, we’re examining additional ways compensation and benefits can attract and retain key employees as well as provide incentives for employees throughout the organization to do what’s best for the client. As an example, we’re looking to establish a 2003 Equity Incentive Plan, subject to shareholder approval. Meanwhile, management-to-employee, employee-to-employee and product-to-product communication has increased, and keeping these lines open between us is a priority. We carried these efforts outside Knight through a corporate awareness advertising campaign launched in January 2003 emphasizing Knight’s commitment to its clients and the establishment of a new philosophy for placing clients first. We also organized multiple events that brought management together with clients, shareholders, sell-side analysts and the media. GROWING OUR INSTITUTIONAL PRESENCE Knight’s ability to improve our reputation directly affects our ability to strengthen our institutional presence. And a strong institutional business is, in itself, an important part of establishing Knight’s pathway to profitability. Let me explain. Knight makes money in essentially three ways: capturing the effective spread; charging fees and commissions for our trade execution services; and managing our inventory of securities as we make markets for our clients. Decimalization and the one-cent Minimum Price Variant have collapsed spreads for Knight and for all of our competitors. Profit margins are being squeezed. Knight believes its trading platform, service level and continuous liquidity make it a standout among firms competing for broker-dealer order flow. Hence, we’re seeking ways to better price the liquidity we offer to our broker-dealer clients. And, accordingly, we are looking at how to grow our higher-margin business – providing products and services to institutions – where we can collect a fee or commission. We recognize that it’s a competitive market. But Knight already is in a particularly strong position to grow a respected institutional business. No other independent firm offers the comprehensive trade execution products and services we do. Our broker-dealer operation remains a top order flow destination feeding a massive pool of natural liquidity, an important strategic asset for the company. Knight can tap this liquidity, commit capital and connect to other liquidity sources across the market to handle the largest, most complex trades for institutions according to their priorities: liquidity, speed, price, low impact or anonymity. Regardless of our natural advantages in the institutional market, Knight is not sitting back and waiting for clients to come to us. We have hired senior-level personnel in cash equities, options, sales, trading and services throughout 2002 and into 2003. And we’ll continue to add people to support our institutional effort. These experts complement the strong skill base of Knight’s veterans, and they are working together to develop new products and services or enhance the ones we have. Finally, Knight’s effort to establish its brand and improve perceptions of the company in the marketplace, as I described, are a critical piece of our institutional strategy. In the end, we want to be the professionals with whom institutions will always want to do business. MANAGING OUR RISKS FOR REWARDS Much of our work – to garner more institutional business, invigorate the broker-dealer business, change corporate culture, establish a brand – is within our control. But other issues are not, and they will impact how well and how long it takes for Knight to reach and sustain profitability. This management team will do everything in our power to manage through these issues in order to attain the best possible outcome for shareholders. When it comes to regulatory and legal issues, for example, Knight is committed to taking whatever steps are necessary to protect our clients, employees and shareholders. We will continue to work cooperatively with the regulators to put any questions and concerns behind us. As we closed fiscal year 2002, we were still operating in a bear market – with large numbers of investors on the sidelines and with no ability to predict when they’ll return. We have made some decisions in the first quarter of 2003 that will impact results going forward. We’re writing down our real estate lease commitments due to the continued recession and overcapacity in the New York metro-area commercial real estate market. The Japanese market, after a decade in and out of recession, still has not recovered. As a result, Knight is closing Knight Securities Japan, its market-making unit operated with partner Nikko Cordial Group. Finally, most painfully, Knight has experienced several rounds of layoffs to better align our operations with these realities. The market, the economy and conflict in the Middle East ... these things make our effort to gain profitability more complex but no less possible. My goal – and the goal of Knight’s new management team – is to position this company for long-term success. The strategy has been established; now it’s up to us to execute. These challenges we face, internal and external, controllable and not, will affect our timetable for achieving certain milestones. But a 12-month “overnight” success, as I like to say, is success nonetheless.