Description

Overview

 

Leucadia National (LUK) is a company that is difficult to describe. The company doesn’t operate any business, it is a holding company that is a bit of a private equity fund, a bit hedge fund and a bit fund of funds. The company has a loyal group of shareholders that seem to just ‘trust management’ and bulls describe it as a mini-Berkshire Hathaway. Management won’t talk to the street, won’t hold a conference call, wont’ attend investor conferences, and generally just releases their mandatory 10Q and 10K filings. There is no street coverage or estimates despite the company’s $10B valuation. However, we believe the long-time investor base has fallen asleep at the wheel and not waken up to the fact that they own a smattering of unimpressive, struggling, and/or money losing businesses and have finances these business with high cost high yield debt.

 

If we agree that LUK is part private equity fund, part hedge fund and part fund of funds, then its current valuation of 1.8x book value makes no sense. Publicly traded vehicles in each of these categories have not been able to sustain premiums to book (keep in mind we are talking about the actual funds, not the fund managers). When we add in the fact that LUK has leveraged its investments with over $2 billion of high yield debt, is highly exposed to housing and resources, and its core operating units are struggling: 5 out of 7 units lost money in 4Q (profitable units generated $7m pretax, unprofitable units lost $35 million) - - - it would seem to me that the shares should be trading at a discount to book value, rather than a premium.

 

Accounting

 

We will describe LUK’s business units in three groups that are consistent with the accounting treatment and thus make it easier to follow from the company’s balance sheet. These three groups are 1) Operating Subsidiaries which are consolidated on LUK’s income statement and balance sheet, 2) Equity interests where LUK holds an interest in a company but does not exercise control. LUK’s percentage of the net income of the companies run through the income statement as “equity interest”, and 3) investments in hedge funds. The way we think about each is that we consider companies that are Operating Subsidiaries to be private equity investments because they are not publicly traded and LUK exercises control to improve operations, change management, etc. We think of equity interests in companies similar to hedge fund investments as these investments largely are made in public companies and are marketed to market each quarter through the balance sheet. Finally, the company’s investments in hedge funds we think of as a fund of fund business as they are simply allocating money to other managers and paying full fees.

 

Operating Subsidiaries

 

Below we will give brief descriptions of each of the operating subsidiaries

 

Timber – not to be confused with owning a forest and chopping down trees, LUK’s timber business is a manufacturing business that supplies to construction companies. This business buys the wood, processes it and then sells to builders. Needless to say, this business is not performing well given the slow down in construction. In 4Q, revenues were down 27% and pretax losses were $2 million. We see no reason why this business would trade at a premium to book.

 

Plastics – this is also a manufacturing business exposed to the construction cycle. Its difficult to make year over year comparisons because they completed an acquisition in early 2007, but with the acquisition, revenues were up 6% and pretax was $4m, up from $2.5m. We don’t know LUK’s cost basis in this business, but given the small size its likely immaterial to overall valuation.

 

Telco – this business sells prepaid calling cards and was acquired in 1Q07. In the first quarter after purchase, quarterly revs were $111m, in 4Q revs were down to $106m. Management does not blame seasonality, they say simply Telco management got distracted during the year because of the transaction and ended up losing some distributor relationships. Given LUK’s purchase price from last year represents its book value and the company has underperformed, this business is likely worth less than book value today.

 

Property Management – vacation rental management and real estate brokerage. Probably don’t need to say much more, the division is clearly struggling and lost $11m in 4Q. Not worth a premium to book.

 

Gaming – LUK bought the Hard Rock Hotel, Biloxi out of bankruptcy. It was hit by Hurricane Katrina just before opening so its been rebuilt and launch summer 2007. So far, results have been disappointing (management’s commentary, not ours) as the hotel and casino are not attracting enough visitors. Pretax losses in 4Q were $7m. Because of the recent purchase and struggles, this business is likely worth less than it was at acquisition and thus worth a discount to LUK’s book value on the investment.

 

Equity Interests

 

Fortescue (AU FMG) – an absolute home run! LUK invested in this Australian company that plans to mine Iron Ore. The company has yet to produce any revenues or earnings as it is currently building out infrastructure, but the market is giving it high chances of success. Shares have roughly moved from AU$2 to AU$8 in the last year. LUK marks this investment to market so the gain is already reflected in book value at the current market price. Because the investment is marketed to market, its value to LUK should be current book value.

 

Goober – an oil drilling contractor. LUK had to extend loans to the company last year due to increased raw material prices, increased labor costs and rig delays. LUK invested about $300m. We don’t know how to value, but given management’s commentary, its sounds that the company has disappointed in 2007 and hard to argue its worth more than the price of its recent investment.

 

Inmet – an investment (through a company Inmet acquired) in a Canadian listed mining company. There is an unrealized gain in the shares of approximately $300m and book value is $70m. If we were to mark to market, book value increases by approximately $1.

 

HomeFed – California real estate developer that is publicly listed (HOFD). The negative trends here are well documented.

 

Hedge Funds – Jefferies Partners, Wintergreen, EagleRock, Highland Funds, Pershing Square, RCG Ambrose, Union Square – these are all hedge funds that LUK has made investment in. All are marked to market and the total investment in hedge funds is approximately $400m. They plan to increase their investment in the Jefferies Partners funds by another $250m. As discussed below, we believe this is a poor allocation of capital.

 

Americredit – in early 2008, LUK has purchased over 20% of Americredit, a subprime auto finance company that is experiencing increasing chargeoffs and delinquencies and has not been able to access the capital markets to securitize its receivables. The company relies on the securitization market for funding. We don’t know how the Americredit investment will work out, but few investors would have the courage to finance their purchase of these shares with high yield debt the way LUK has. ACF shares currently trade about 10% below LUK’s purchase price.

 

Inefficient Operating Structure and Poor Allocation of Capital

 

In general, we hate to see public companies making investments into hedge funds. Most investors can invest in hedge funds at exactly 1.0x book value and pay only one layer of taxes and overhead. When LUK invests in a hedge fund, just think of the returns that a hedge fund must generate in order to earn an adequate return to LUK shareholders. For example, let’s say LUK invests $100m with a hedge fund and consistent with their capital structure funds 25% with high yield debt and 75% with equity. If the fund manager generates a 15% return net of costs excluding management fees (pretty good in an average market), then takes out his 2&20 taking the fund net return down to 10.4% to LUK. Then LUK will need to cover some G&A and management’s time so let’s say that costs 50 bps, and will have to pay interest on the 25% financed with high yield debt (at 8%) so our pretax return comes down to 7.9%. After the 40% corporate tax rate we are down to a 4.7% unleveraged return or a 6.3% levered return on equity. An individual investor would then need to pay taxes if/when these earnings are distributed, thus municipal bonds would yield a better return to the end investor that the expected returns LUK will generate from its hedge fund investments. Is this really a good use of capital?? LUK currently has $400 million invested in hedge funds and best I can tell, these investments should be worth less than book value due to the multiple fee layers and inefficient tax structure.  The most egregious example is LUK’s recent investment in Pershing Square LLC. The stated objective of Pershing Square is to purchase stock in Target (TGT). If investors want exposure to TGT, they can simply buy it themselves in the open market, pay no management fees and avoid multiple layers of taxes. I see no reason why investors award LUK a multiple on book if the best investment opportunity they can find to allocating capital to someone else to purchase a single stock.

 

Can LUK Service its Debt?

 

On an operating basis, LUK loses money and must rely on investment gains to service debt. This works well in a bull market. However, as we see from the company descriptions above, none of the operating businesses are generating sufficient cash flow to service the over $100 million of interest due each year. In 2007, operating income (before interest expense) was $54 million and that included securities gains of $96 million. Excluding securities gains, operating income was a negative $41 million. In a protracted bear market or even one with minimal appreciation, LUK will likely be forced to sell investments at unfavorable prices to service their debt.

 

Deferred Tax Asset

 

LUK has a sizeable $1.1 billion deferred tax asset on its balance sheet that accounts for 20% of equity. Half this deferred tax asset was put on the balance sheet in 4Q07 (and ran through the income statement, resulting in an impressive GAAP number that masked the large operating loss in the quarter). Usually deferred tax assets are increased when the company has good visibility on coming profitability, which seems questionable in this case considering LUK lost $74m from operations in 4Q07 and lost $57 million from operations for the full year.  Best we can tell, the increased asset must be because Fortescue stock increased meaningfully in 4Q and thus the company expects a realized gain coming some time in the future and the increase in the deferred tax asset was to reflect this appreciation. However, this means that the book value of LUK is doubly exposed to Fortescue stock (AU FMG) as a decline in the FMG stock price would likely lead to a write off of the deferred tax asset. If Fortescue ultimately is less than hoped (keep in mind they have yet to produce any revenues) and shares return to a year ago level, the negative mark on FMG stock and the writeoff of the deferred tax asset could take LUK’s reported book from $24 to $13.

Catalyst

Lack of a catalyst is the weakness in this short idea. The company has no research coverage and no earnings estimates to miss. The one potential catalyst is the company's large exposure to a single company Fortescue Metals (FMG in Australia) and this company accounts for about half of LUK's book value. FMG shares could be a risky bet as the company has yet to generate revenue.