Description

Leucadia was written up by ladera838 in December of 2015 and alex981 in October of 2014.  Leucadia recently changed its company name back to Jefferies – for this write-up, we will use JEF when referring to the entire company and Jefferies when talking about the investment bank.  Despite record results from Jefferies and National Beef in 2017 (both assets were severely struggling when ladera838 profiled the name), monetizations of National Beef/ Garcadia and a new repurchase program which retired over 5% of outstanding shares in ~6 weeks, JEF is hated again, falling nearly 15% year-to-date.  While the name traded at a lower price/book ratio when ladera838 last profiled the name, JEF’s balance sheet, liquidity and business momentum are far stronger today.  Two key tenets of the JEF thesis are: 1) Jefferies has some franchise value (and thus deserves a premium to tangible book value), 2) Richard Handler and Brian Friedman are good capital allocators.  At current levels, however, the stock’s current valuation and visibility on further repurchases probably put a floor on fundamental downside. 

 We quickly summarize developments over the past 18 months:

·        The two largest assets posted record 2017 results.  Jefferies posted record 2017 revenue/net profits of $3.2 billion of $358 million ($505 million pre-tax).  Meanwhile, National Beef, which was EBITDA negative in 2015, posted record 2017 EBITDA of ~$512 million. 

·        Fitch upgraded both Leucadia and Jefferies to BBB, and Moody’s placed Leucadia’s ratings on review for upgrade.  In January of this year, JEF approved a $200 million distribution from Jefferies to the holding company and further announced a policy of paying 50 percent of net earnings and payments related to tax sharing agreements between JEF and Jefferies.  The arrival of Jefferies’ distributions to the holding company has taken far longer than anticipated but this is critical step for more aggressive share repurchases/further deals, etc.  The distributions should improve the various Jefferies ROE metrics.  While this Jefferies’ “float” back to JEF will be volatile, it should provide JEF a steadier stream of earnings to invest that the historical Leucadia ever enjoyed.

·        JEF monetized 49% of its 79% stake in National Beef for a total implied equity value of roughly $1.9 billion.  JEF will receive cash proceeds of $1.050 billion in cash (14% of market capitalization) which includes $150 million in JEF’s share of National Beef profits and other distributions.  JEF’s remaining 31% will be valued at $590 million.  JEF’s previous 79% stake was actually marked at a negative tangible value of (-$37) million as of 12/31/17. 

·        JEF monetized its ~75% ownership in Garcadia for $435 million in cash/$50 million preferred equity ($220 million gain).

·        JEF energy subsidiary Vitesse Energy agreed to acquire a package of non-operated Bakken assets for $190 million in cash ($45 million of the payment was drawn from credit lines).  The transaction roughly doubled the size of subsidiary’s Bakken assets with the subsidiary acquiring 4,200 boe/day of flowing production and 23,000 net acres in the Bakken Core.  85% of the assets have not been developed.

Netting out the various transactions, Jefferies will receive total cash proceeds of roughly $1.1 billion (The National Beef transaction closed this week).  JEF increased the buyback authorization to 25  million (from 12.5) shares and announced in May that it had repurchased roughly 20 million shares or over 5% of outstanding shares in ~6 weeks. 

JEF popped nearly 12% on the day of the asset sale announcements, but it surrendered nearly all gains.  The pullback likely stems from interest rate/macro concerns and their near-term impact on Jefferies’ business.  The sharp decline in HRG shares probably hasn’t helped sentiment on JEF capital allocation abilities. 

Obviously, Jefferies is the largest asset and any JEF investor needs to gain some comfort in this volatile earnings stream.   We do not think Handler receives nearly enough credit for his track record from 2000-2013 which obviously encompasses multiple market cycles.  This performance combined with the large huge personal ownership stake should provide some comfort to those who worry Jefferies’ balance sheet during down markets.  The limited amount of Level 3 assets and historical leverage ratios (even leading up to the 2008/2009 crisis) also help on the comfort front.

(2000-2013 Returns - See link from company presentations - chart not uploading correctly)

That said, Jefferies results (2017 excluded) since the JEF/LUK merger have been considerably worse than historical levels.  While Jefferies expansion efforts since the Great Recession have expanded the franchise, Jefferies wasn’t perfect, particularly with the $430 million purchase of Prudential Bache.  Jefferies sold/shut down most of the business in 2015. 

We show the past 11 years of Jefferies’ results and would make a couple of observations.  First, the incremental returns on the core banking business have not been strong.  To generate earnings with incremental capital, Jefferies has to either hire more teams of bankers or increase risk assets on the balance sheet.  One can argue that the expansion since the crisis has filled strategic holes and made strengthened the company’s global bank profile.  This might make the franchise more attractive to a future partner.  While Bache and market issues hurt recent results, the other problem has been the buildup of capital at Jefferies, capital that likely could have been better served at the holding company.   Finally, it should also be noted that Jefferies should benefit from the lower corporate tax rate as previous returns reflected the 35 percent corporate tax rate.  This lower rate combined with the remaining $2.3 billion of NOLs should effectively allow JEF to realize after-tax returns that mirror pre-tax results for at least the next 3-4 years.

Record 2017 results along with decent Q1 results in a volatile market environment suggest the business has some operating momentum.  We suspect that the exact multiple that investors ascribe to Jefferies will likely depend in part on how distributions are invested.  Admittedly, investment banking is a volatile business, and many will assume there is zero franchise value every time there is a down quarter.  But, as previously noted, we do think the payment of trapped capital is an important step in potentially unlocking value.    

There are also various arguments about the whether the FICC business is in structural decline or whether the end of quantitative easing/increased volatility will ever lead to renewed revenue.  We don’t have a strong view – we would simply state that results anywhere near the last several quarters should help rerate the stock.  We would also note that Handler has long talked about the limited number of independent global investment banks, and despite the struggles across the sector, it is not impossible to think that another bank may want to enter the US again in the future.  The strategic alliance with BOC International (a subsidiary of The Bank of China) announced earlier this year did not involve an equity investment, but it is not unreasonable to think that this type of relationship (not necessarily with BOC) could morph into something else.  Any minority investment in Jefferies would likely be done at a substantial premium. 

Absent a deal for a minority investment in Jefferies, one of the clear debates with JEF is the proper multiple to ascribe for Jefferies.  One can rightfully argue that the bank should never trade at a premium to Goldman Sachs – why own Jefferies if one can buy a higher quality bank at a similar price?  We would argue that part of the appeal for Jefferies lies in JEF’s ability to deploy excess capital to other higher earning merchant banking businesses.  While Dodd-Frank might be watered down going forward, GS still has meaningful restrictions on deploying capital today versus in past years and certainly has less freedom than JEF.   Should multiples among the US broker dealers retreat, this will be a headwind for JEF’s overall valuation.  But, as we will detail, we also believe that investors will likely look to the performance of the redeployed capital over the coming years.  We include the various advisor boutique banks simply as a data point – clearly their valuations incorporate a capital light model that investors ascribe higher valuations despite the advisory dependence risks and often risks associated with a small group of employees. 

Source:  Bloomberg

As noted, in addition to gaining comfort on Jefferies, an investor also must believe that Handler/Friedman are strong capital allocators.  Obviously, the historic track record gives some comfort, but one can also make some judgements on the various changes both have made since the JEF/LUK merger.  Handler/Friedman have simplified large parts of the JEF story, eliminated several of the more venture investments, provided a more rigid framework for position weightings with the rating agencies (not 100% popular among historical Leucadia investors) and invested in several platforms. 

We won’t detail every single investment but will comment on a couple parts. We would generally argue that Handler/Friedman have acquitted themselves well on most major capital allocation decisions.  The HRG investment was well timed (taking advantage of Falcone’s liquidity need) and the team deserves substantial credit for cutting HRG corporate expenses, selling Fidelity & Guarantee at a good price/in a tax efficient manner, and negotiating a favorable deal with Spectrum Brands (SPB) on remaining tax assets.  Obviously, the investment (cost basis of $10.21) certainly looked much better when the stock traded closer to $20 but SPB looks cheap relative to its free cash flow/tax assets and a rebound could be a source of upside.  A spinoff of SPB shares at a later date could be a distinct possibility.

FXCM provides F/X services to retail accounts and was purchased following the de-pegging of the Swiss Franc in 2015.  Business results have been hurt by low currency volatilities but should benefit as this volatility increases.  Following a lawsuit from the U.S. Commodity Futures Trading Commission, FXCM withdrew its application from the US and now operates solely overseas.  Through March 31, 2018, JEF has received cumulatively $339.8 million of principal, interest and fees from its initial $279.0 million investment in FXCM.   The remaining $73 million term loan currently accrues interest at 20.5% annually.  JEF still owns ~50% of the equity and is entitled to up to 65% of the economics (following repayment of the term loan).  Despite some operational setbacks, the FXCM investment was purchased well and is the exact type of distressed investment that LUK hopes to replicate in future years. 

While Ian Cumming rightfully deserves substantial praise for the National Beef purchase, Handler/Friedman also deserve credit for holding the asset despite the 2015 losses and despite their belief it was too large relative to capital levels.  The rebound in National Beef’s business has probably exceeded even the most bullish forecasts.  Time will tell if JEF picked an opportune selling point, but the partial sale allows them to monetize a substantial portion while maintaining some exposure to an asset that should benefit from more limited new processing capacity.  We would also note that the National Beef/Garcadia sales also signal that Handler/Friedman are actively working to simplify the JEF story and drive shareholder returns.    

It is still unclear if the energy investments (Vitesse and JETX (formerly Juneau)) ultimately produce acceptable returns.  The returns have thus far been subpar.  As of 12/31/17, JEF had invested $564 million in both names but marked the two investments at $417 million.  The damage actually could have been far worse given the investments were made prior to the energy downturn.  The most recent $190 million Vitesse investment is a bit of a doubling down on the Bakken assets but looks to be better timed, albeit still dependent on forward prices.  At the 2017 investor day, JEF noted that drilling costs have fallen 30-40% since 2015 but reserves in new Bakken wells have increased 40 percent, suggesting stronger returns from new wells.

Leucadia Asset Management has achieved little traction thus far.  The anchor investment in Folger Hill did not go as planned, with the firm reportedly returning capital last month and merging with Schonfeld Strategic Advisors.  Handler has noted that it will take time for JEF to build the business organically, but preferred this route versus a more expensive acquisition.  At the very least, one would have hoped for better returns on JEF’s own capital (Folger Hill reportedly lost -17.5% in 2016).  JEF still appears optimistic on their ability to build a franchise. 

We believe that JEF missed a great opportunity to repurchase shares in late 2015 (high $15-$17 range).  As noted, both Jefferies and National Beef were losing money and there were concerns about a possible Jefferies downgrade should the firm have been more aggressive.   Handler has noted that while he might have missed the low tick on the stock, markets would likely provide another opportunity.  This moment seems to have arrived.  We show both an estimated net asset value adjusted for the recent divestitures/share repurchases and a straight tangible book value as of 03/31/18. 

With the stock at roughly 70 percent of a relatively conservative NAV and at discount to tangible book value, share purchases are highly accretive.  And unlike 2015, the underlying Jefferies and National Beef businesses are coming off record profits.  JEF has been more active repurchasing stock at any time since the Leucadia merger closed.  With cash totaling nearly 14% of its market capitalization soon to arrive, we think further retirements are likely.  Even if sentiment remains poor (JEF will sell-off on “risk off” days), we believe the company can continue buying and still have substantial firepower for future acquisitions.  With shares below tangible book value and considering the soon to be received cash proceeds, downside appears to be well contained.

We would make two final notes on compensation and investor outreach.  One of the criticisms of Jefferies in the past revolved around compensation levels for Handler.  While the dollar payouts were often large, we thought the criticisms were less relevant given the longer-term performance and the individual equity holdings.  Other than gifts to charities, Handler has held on to all shares (he currently owns 3% of outstanding shares) and is currently one of the largest shareholders.  By any definition, he has substantial skin in the game.  That said, JEF’s more recent compensation arrangements are an improvement, albeit far from perfect.  The 2018 compensation plan used targeted awards essentially based on 3 year total shareholder returns (TSR) and 3 year returns on tangible equity (they call it return on total deployable equity).  The targeted returns (3 year CAGR) is 8% (with 50% upside up to 12%)  and the minimum threshold is 5% (vs. 4% in 2017).  The cash portion of the payout is based upon ROTDE and the equity portion is based on TSR.  Clearly, investors will look towards the underlying book value per share growth in coming years as they evaluate the entire merchant bank.  While 10 percent+ growth would clearly warrant a rerating, 8 percent growth would actually be a decent acceleration from historical levels and still warrant some improvement in valuation metrics.    

While JEF’s current investor relations efforts are light years ahead of anything that legacy Leucadia ever employed, JEF probably could make some minor tweaks that make it easier for investors to understand a more complicated name – this is a major complaint among some holders.  We don’t think quarterly conference call/multiple industry conferences are necessary, but a single head of investor relations who can speak articulately about both Jefferies and JEF’s other businesses would be helpful.  Webcasting the annual meeting and a cleanup of the Jefferies/Leucadia websites wouldn’t hurt either.   With the recent divestitures, we think it is likely that other sell-side analysts may initiate coverage on the name.  More importantly, JEF is currently trying to move its other businesses to the same November fiscal year as Jefferies.  This change is a priority as it will make comparisons easier, but, critically, the change will remove the extra blackout periods.  Amazingly, JEF currently has had eight different periods (for Leucadia and JEF) which have hindered share repurchase efforts.  With the stock at current levels and liquidity levels this high, this change should be implemented as quickly as possible.

While JEF shares jumped from 2015 lows, the stock has disappointed since the Leucadia merger.  That said, we think value has been created and the recent weakness provides a nice risk/reward entry point. 

Risks:

·       Key person risks (Handler/Friedman)

·       Slowdown in capital markets activities/more severe losses on existing risk exposures

·       Slowdown in distributions from Jefferies to holding company

·       Losses at Leucadia Asset Management

·       Permanent impairments at other holding companies/bad future deals

Catalyst

-Larger share repurchases

-Sell-side coverage

-Rebound/Spinoff SPB