Description

I'm recommenting a short position in Jefferies Group (JEF) - its an overvalued mid-tier investment bank that has used aggressive accounting to give the appearance of profitability and since it isn't generating cash earnings, its burning through cash forcing it to ramp up the leverage on the balance sheet. On an econcomic basis I don't believe this company earns money, but even using their misleading GAAP accounting, this is one of the least profitable firms in the brokerage industry yet trades at a significant premium to quality franchises such as Merrill Lynch (MER), Goldman Sachs (GS), and Morgan Stanley (MWD).

JEF P/2004E EPS: 21x
JEF P/2005E EPS: 20x
JEF P/Book: 2.8x (removed restricted stock component for comparability)
ROE 12%

GS P/2004E EPS: 12x
GS P/2005E EPS: 12x
GS P/Book: 2.2x
ROE 18%

MER P/2004E EPS: 13x
MER P/2005E EPS: 12x
MER P/Book: 1.8x
ROE 14%

MWD P/2004E EPS: 13x
MWD P/2005E EPS: 12x
MWD P/Book: 2.2x
ROE 16%

I do not believe this company makes a true econcomic profit despite reporting GAAP profits. This is because the company is artifically understating its compensation expenses by issuing massive amounts of restricted stock. The company has been aggressively hiring staff, staff which is producing revenues today, but because restricted stock is expensed over the vesting period, only a fraction of true compensation costs are expensed today. This will eventually catch up to the company. If the company were forced to expense its annual run-rate issuance of restricted stock, the company would not make money.

In the first 9 months of this year, Jefferies issued 4.0 million shares of restricted stock with an estimated value of $119.9 million (direct from 10Q). Most restricted stock issuance occurs in 1Q for bonuses, but not all - 700k shares of restricted stock were issued in 3Q alone. If we assume another 700k shares will be issued in 4Q, this will get us to 4.7 million shares issued in all of 2004 and using their same assumed $30 share price (even though stock today @ $42), the company will issue $141 million worth of restricted stock to employees in 2004.

To keep from drowning in share dilution, Jefferies aggressively repurchases stock in the open market. This also artifically pushes up the price. In 3Q alone, Jefferies spent more on share repurchases than it earned in the quarter. So on a normalized basis, if Jefferies is issuing $141 million worth of restricted stock annually, we would also expect it to repurchase $141 million worth of stock in the open market. If their share prices increases over time, as it has, then they will need to spend even more, but to be conservative, I will assume the company needs to repurchase $141 million annually.

In 3Q, Jefferies reported net income of $32 million. To get to a cash number, I add back the aftertax amortization expense of restricted stock of $9 million so I get to quarterly cash earnings of $41 million or $164 million annually.

So the result is that we have a company that needs to spend $141 million in share repurchases just to keep their share count flat, yet generates only $164 million of cash earnings annually! This means that the company really only has $23 million left for shareholders annually or $0.36 per share versus the $2.00 of earnings the company claims through its GAAP accounting. The $23 million of cash left for shareholders is barely enough to cover the company's annual dividend.

The Jefferies balance sheet supports my thesis that this company is not generating cash earnings. From 12/31/03 to 9/30/04, Jefferies took out $176 million of bank loans and increased its long-term debt from $443 to $789 million. So collectively, debt has increased by $522 million in 9 months while its cash balance has only increased by $128 million. Yet despite this increase in leverage, ROE remains embarassingly low @ 12.0% in 3Q - despite the quarter including 4 more trading days than normal and the quarter experienced $20 million of non-recurring revenues.

Finally, the company overstates its book value by including restricted stock issuance in equity rather than as a liability (they changed to this method in 2003). This has inflated their book value by approximately 10%. My price / book calculation above excludes this overstatement. In the most recent quarter, shareholders equity increased $18 million from $949 million to $968 million. However, restricted stock issuance (since its issued above book) added $32 million to equity, in other words, book value would have declined except for the continued restricted stock issuance.

I believe the only people that will ultimately make money from Jefferies stock is Jefferies employees. By the time they give themselves stock and then use shareholders funds to repurchase that same stock, there is just no economics left over for shareholders.

Catalyst

Leverage on the balance sheet is exploding and the company may need to curtail its excessive share buyback program which has been artifically supporting the stock. Without the buyback program, sharecount will experience massive dilution.