Description

Leucadia National is a conglomerate trading at 77% of book value and 71% of my estimate of intrinsic value. This name is probably familiar to many of you, and certainly the name is no stranger to VIC.  Financials have gotten hit over the last week, and hedge fundy names, as well, so a double whammy for this stock. I think it’s gotten to the point where it’s attractive, even if it isn’t statistically the cheapest stock you’ll ever see. Capital allocation and management are outstanding, and I think they’ll be able to grow book value and intrinsic value at a double digit rate over the coming years.

To start, some caveats:

1. This is largely a management story. I’ve looked at Rich and Brian’s record at Jefferies, and I’ve come away impressed. I’ve heard them talk about the business, and I’ve come away impressed. I think they think the right way about capital allocation and building value. If I’m wrong, this probably doesn’t work, cheap as it is – they will keep retaining capital and investing it in new businesses, and if they don’t invest wisely they’ll destroy value.
2. This also hinges on whether Jefferies ends up being a decent business. I personally think they will earn a good return on equity over time. If you are bearish on broker-dealers and investment banking, you will dislike this stock no matter what. Jefferies is half the value here. Just hit the “2” button and stop reading. No problem.

History

Ian Cumming and Joe Steinberg built Leucadia from almost nothing to a $10 billion company over the course of 30-odd years by making a lot of intelligent deals, mostly for distressed assets at bargain basement prices that also came with enough tax benefits to the point where I don’t think Leucadia has ever mailed a check to the IRS. If you invested $10,000 in Leucadia stock in 1978, you probably should stop reading this and go back to munching caviar on your yacht or bidding on priceless artwork. Enjoy life!

If somehow you haven’t read Leucadia’s past annual letters, you should do so – they’re all online. If you’re pressed for time, just the last one, which recaps their history, should do. They serve as a good introduction to the business, and provide some good case studies in investing awesomeness.

That was all well in good until 2012, when they decided to retire. They bought the 70% of Jefferies they didn’t already own in a stock deal, and appointed Rich Handler and Brian Friedman, who had been running Jefferies, to oversee the whole business. The deal closed in March 2013, and since then they’ve been busy divesting a few unwanted assets and investing in a few new ones.

Thesis

The stock trades for $21.88 a share. Book value is about $28.50 per share. Intrinsic value, in my opinion, is higher than that, at around $31. That’s just the standalone value; if you believe management will create value, it will be worth even more!

Valuation

The company provides a handy chart mapping out all of their business in their investor presentations, and the most recent one was in the Jefferies investor presentation last week, found here. Broadly, there are three segments – Merchant Banking, Other Finance, and Jefferies.

Merchant Banking 

Most of these are leftovers from pre-Jefferies Leucadia, though some are new. I’ll just offer some brief comments on each. More detail on each business is available if you read the Leucadia investor day presentation from last month, here. They plan on continuing to do a couple each year, as opportunities present themselves from the banking pipeline.

National Beef – This is a meatpacking business they bought in 2011, and since they acquired it, high beef prices have squeezed margins. I don’t have any great insight except that this is a volatile, commodity business that has ok returns on capital. The acquisition created a sizeable intangible asset that is being amortized, so as time passes the gap between book value and intrinsic value is widening significantly. However, you can back into the fair value by looking at the minority interest, which has to be revalued continuously since Leucadia will have to buy it out in a few years. This is where my valuation comes from. 

Harbinger – This is a deal Jefferies did, and it looks to have been a good one. They paid $8.50 a share and now it trades at $12.50. They think it’s worth a bit more than that. HRG has been written up on VIC recently, so refer to that. It’s carried at market.

Vitesse – A venture formed this May to buy up some acreage in the Bakken and partner with others to drill it. I’m leaving it at book value but clearly energy prices haven’t gone the right way.

HomeFed – Owns land and real estate, again it’s been written up on VIC recently (HOFD) so you can refer to that. It’s being carried closer to historical cost because the stock is illiquid. I’m using the current stock price, illiquid or not.

Linkem – They’re building out LTE in Italy. It’s more of a venture investment but they’re using equity method to account for it so it’s carried below cost because of cumulative losses. They’re growing subs but I don’t have much insight into telecom in Italy.

Garcadia – Leucadia has been buying up car dealerships since 2007 in a JV, and it’s been paying off. Absent better disclosure I’m using 10x the average of the last 3 years of earnings to get a reasonable valuation. That might be low for Garcadia since they’ve added a couple of dealerships. They continue to buy dealerships.

Juneau – Another new energy venture similar to Vitesse. Carried at book.

Conwed – A business that manufactures plastic netting, originally acquired as part of conglomerate they bought in the 1980s. They’ve kept it over the years as it has produced a good return on capital, and they’ve made some bolt-on acquisitions recently as well.

Idaho Timber – Bought it in 2005, the company remanufactures lumber, and the collapse in the residential housing market really hit it.  They made $8mm before tax in the first half of this year, so I’m optimistic the original cost is more representative of the value.

Golden Queen – New gold/silver mining JV.

Other Finance 

Berkadia - A 50/50 JV with Berkshire Hathway that bought a commercial mortgage origination and servicing business from Capmark in 2009. It has already repaid the full investment and the venture produced $153mm in pretax earnings last year, and is on pace for the same this year. The volume of originations varies quite a bit from year to year, so I used 10x the average of the last 3 years (2011-2013) to get to my valuation.

Leucadia Asset Management – They have decided to build rather than buy an asset management business.  You have probably seen the headlines where they are looking to stake the former COO of SAC to the tune of $400mm for 50% of the business in a seeding deal. If you saw Bill Ackman’s last letter, you know they staked Pershing originally but turned down the chance to take 25% of the management company. Oops. Hopefully they do better this time around.

Jefferies 

This brings us to Jefferies. Jefferies is a full-service investment bank. They have built the business over time, both organically and with small bolt-on acquisitions. I think Jefferies and the other mid-sized boutiques that have some scale will continue to thrive. They can avoid the regulatory scrutiny that comes with being a SIFI and the attendant costs, regulations, and headaches.

My view of the industry overall is that parts of the business are very attractive and parts of the business are not. You have some publicly traded boutiques that don’t have trading operations and thus don’t have the big balance sheets that go with it – GHL, EVR, MC, LAZ, and the BX spinoff will join them. Until recently these stocks have done very well in the market. They have the same economics of any other professional services business – high ROE, maybe a little lumpy, but if they have strong enough client relationships (and can replace the ones they lose at a reasonable cost), they’ll generate good shareholder returns.

I think you can think of the trading business somewhat separately from the advisory/capital markets business. Emphasis on somewhat. To some extent the trading business supports the capital markets business in that it helps win underwriting business. Arguably it can create conflicts as well. I think that over time Jefferies can wring an acceptable return out of their trading business and that combined with the highly profitable investment banking business underpins my valuation.

Over the LTM, Jefferies did $593mm in pretax earnings on $3.4bn in revenue. Half of revenue is derived from advisory and capital markets; $583mm from advisory and $1,048mm from capital markets. They’ve grown this business quite nicely; in 2007, the last peak year, advisory revenue was $362mm and capital markets was $389mm. So, they’ve more than doubled investment banking revenue over the last seven years.

I don’t think they’ll keep growing so quickly, but profitability should continue to improve a bit. Over the past few years they have hired to grow the business which had depressed profitability as the bankers they hired were paid before they started producing. I think they’re getting close to run-rate profitability here, but of course results are very volatile from quarter to quarter and year to year.

Jefferies has a book value of $5.6bn, but this includes $2bn of goodwill and intangibles, of which $1.7bn is from the Leucadia-Jefferies merger. Since it was a stock deal, the goodwill number is slightly arbitrary – the number was based on the closing price of LUK when the deal closed. However, I think it approximates the fair value of Jefferies today. The way I think of it, Jefferies has $3.6bn of tangible book value and $2bn reflects the premium for the capital light advisory/cap markets businesses. I think $2bn is a fair premium for a business that generates $1.6bn in annual revenue (and probably well over $300mm in profit before tax) on little or no capital. If you look at the comps like EVR, GHL, etc. on this basis, you can see that this is definitely a lower multiple than the comps trade at.

The flip side of this sum-of-the-parts analysis is that the capital intensive businesses haven’t earned a great return. If you look at the JVs they’ve done here, Jefferies High Yield, LoanCore, and Jefferies Finance, you can see some of that. I think they want to get the combined ROE up closer to 10% after-tax, and I think there is a path to get there. But, if they don’t, I could see them trimming back and using the capital for other purposes.

Cash / Debt

Leucadia is in a net cash position at the holding company level. They have around $1.6bn in cash and $1bn in debt, pro forma. I think that’s a good place to be.

The last item is the NOL. Leucadia managed to do a transaction with WilTel, a troubled telco company that somehow resulted in Leucadia not only acquiring all of their NOLs but being able to use them to cover all of Leucadia’s businesses. It seems impossible but they pulled it off. This will monetize over the next 5 years or so – the gross amount is nearly $4bn but Jefferies does $600mm pretax each year, the big merchant banking subs that generate income do about $300mm pretax a year combined, and income might grow going forward. You have to discount the balance sheet value since it doesn’t account for the time value of money. I discount it about 10%, figure on average it will monetize in two years or so and discount it at 5% a year. This is a very rough method but it will turn to cash and it is valuable.

Catalyst