Description

Long Idea:
Leucadia National Corporation (LUK),is a publicly traded investment company, which I view as a hedge fund proxy of the highest order, boasting an investment and management team without peer, wonderful and proven long term durability in their returns, and daily liquidity on your investment (trading at a slight premium to book but without the 20% profit reallocation).

Leucadia National through its subsidiaries, engages in telecommunications, healthcare services, manufacturing, banking and lending, real estate, and winery businesses. It owns or leases, and operates a fiber-optic network that provides Internet, data, voice, and video services; and transmits audio and video programming over the network, as well as distributes advertising media in physical and electronic form. The company provides physical, occupational, speech, and respiratory therapy services, as well as healthcare staffing services and Medicare consulting services. Leucadia National also manufactures and markets lightweight plastic netting used for various purposes, including building and construction, erosion control, agriculture, packaging, carpet padding, filtration, and consumer products. In addition, it involves in domestic real estate operations that include commercial properties, residential land development projects, and other unimproved land; offers banking and lending services, as well as operates two wineries that produce and sell wines in the premium table wine market. Additionally, the company engages in property and casualty reinsurance; and property excess, marine, and aviation reinsurance, as well as develops a copper mine. Leucadia National was organized in 1968 and is headquartered in Tulsa, Oklahoma.

INVESTMENT THESIS

LUK is involved in a collection of business adventures and ventures. They look for value anywhere – banking, natural resources, consumer, retail, insurance, real estate (all types – raw land, residential development commercial, industrial), energy, utilities, timber, healthcare, manufacturing, airplane leases, and hard-money loans. Over the last 30 years, Cumming and Steinberg have probably completed over 100 bankruptcy deals. Bottom line, they are extraordinary deal-makers – at buying & selling. They buy depressed assets, repair them and then sell them. This strategy has made LUK a better investment over the last 30 years than even Berkshire-Hathaway. LUK’s total return to shareholders since 1975 comes to about 29.5% annualized – or the equivalent of doubling your money every 2.44 years.

LUK is not an earnings driven company. It is about book value. Insiders own about 25% - Cummings & Steinberg own about 16% together. Over the years they have occasionally sold stock, but never much stock. The company shows no penchant for public relations. You never see any publicity on the company. Tangible book value is currently about $3.5 billion or $33 a share. Keep in mind that they carry their assets at “cost” on the balance sheet as opposed to “market value.” At $47 per share, LUK is trading at 1.43x book value.

The management of Cummings and Steinberg remains obviously the most important asset. LUK currently has about 35% of its market cap sitting in cash on its balance sheet. I can think of few other places that I would rather allocate capital than with LUK during the next credit cycle downturn.

STRATEGY

Ian Cumming and Joseph Steinberg strive to purchase out-of-favor assets at steep discounts to fair value, then work to extract value. Leucadia's managerial skill and strict discipline of not overpaying for acquisitions prove successful time and time again. The firm seeks to purchase companies that provide products or services with low obsolescence risk, and often finds acquisition candidates in disheveled companies that others have given up for dead. These opportunities are often available at bargain prices. Once acquisitions are consummated, Leucadia's team works to extract value by slashing costs and improving the consistency and quality of each company's products and services. In addition, many acquisitions come to Leucadia with huge operating losses that management can use as a tax shield to shelter profits earned in other investments, further enhancing shareholder returns.

Currently, Leucadia's largest investment is telecom company WilTel--a large fiber optic network that leases broadband capacity for phone service and data transmission. When Leucadia acquired WilTel, it also assumed about $30 per share of that firm's accumulated operating losses, which it can redeploy to offset taxes earned by other Leucadia operations--although, at current profitability, only $16 per share is estimated as recoverable. Thus, even if Leucadia's team takes longer than we anticipate resuscitating WilTel, they can use its acquired losses to reduce tax payments elsewhere--rescuing about 30% of earnings from the taxman for shareholders each year until about 2020. What's more, if management starts to deploy its $1.6 billion cash on their balance sheet into attractively priced acquisitions, it will also be able to shelter incremental income from taxes.

Bottom line, Cumming and Steinberg are as smart as they come. I want to invest in them and let them allocate my capital.

CURRENT BUSINESS VENTURES

1. Olympus Reinsurance – privately held partnership in which LUK owns about 19%. Transacts mostly with White Mountains via retrocessional market. Started after 9-11. LUK’s stake is worth somewhere around $400-500 million, and would expect in the next three or four years that there will be a public IPO or something like that. Impact of Katrina looks material but as a private company, almost impossible to determine their exposure.

2. Pine Ridge Wines in Napa and Archery Summit Winery in Oregon – are two separate wineries that produce quality wines. Both entities both own valuable real estate around their respective properties. These businesses were being held out for sale but LUK pulled them off the market. The guess is that some high-end real estate development is shaping up on one or both of the properties.

3. Idaho Timber Company – a recent acquisition. LUK paid cash in the amount of $132 million total for this company. ITC has operations that are wide ranging – Idaho, Texas, Georgia, Kansas, North Carolina, New Mexico, & Montana. I do not know if ITC owns any real estate of significance.

4. Hawaii Hilton Hotel – was a foreclosure deal – LUK bought it in 1993, spent about $30 million fixing it up into a first class Hotel, and it was recently announced that LUK sold it to Gaylord Entertainment for about $110 million. It is hard to tell how much capital LUK put into this deal. Most likely they borrowed all the money on this deal, but if we assume that they tied up $10 million in this venture, they probably cleared $40 to $50 million – or about 4 to 5 times their money – in less than three years. Three years ago, the Hawaiian real estate market was a bust. This deal was typical of Leucadia: buy something in foreclosure, borrow most all the capital needed based on LUK’s credit rating, turnaround the venture, and then monetize their investment.

5. White Mountain Insurance – LUK invested in this John Bryne vehicle at the same time Buffett did. LUK still owns about 325,000 shares – which is up about 400% since purchase.

6. Barbados Light & Power - Leucadia owns approximately 36% of the common stock of Light & Power Holdings Ltd., the parent company of The Barbados Light and Power Company Limited, the primary generator and distributor of electricity in Barbados. LUK’s investment is $12,100,000.

7. HomeFed Development (HOFD) –HomeFed is what is leftover from the old Home Federal Savings and Loan of San Diego (FYI, started by Bing Crosby’s brother back in the 60’s). HOFD prospered nicely until they turned themselves into venture capitalists. The end result was as expected. After HOFD going belly up in the late 80’s – LUK bought HOFD, sold off the branches – and held onto the Real Estate in North San Diego County. This is now known as HomeFed Development. LUK paid a special dividend in 1999, whereby they spun-off the bankrupt HOFD shares to shareholders. I believe both Cummings and Steinberg still personally hold their HOFD stock. In 1999 the stock was trading for around $0.20. Over the next three years, it went as high as $3.25. Then in 2003 LUK bought back into HOFD – buying 30% of the HOFD shares at an equivalent price of about $2.23 a share. Soon after that HOFD did a 1-for-10 reverse-split and since then the stock has about tripled. HOFD owns a large portfolio of ½ acre lots in N. San Diego County that go for $500k in today’s market.

8. LUK is buying the rest of MK Resources that they don’t currently own (about 75%). Once they own 100% of the company, they intend to sell it to Inmet Mining. After this deal closes, LUK will own about 12% of Inmet, around 5.6 million shares. The Las Cruces project in Spain is a huge project that needs another $300M to become an operating copper mine. LUK is still liable for another $50 million at minimum for the new mine. This is a wild card but could hold a lot of potential upside.

9. In 2003 LUK purchased Rehab Works out of bankruptcy (around $50M) – this is a health-care company that provides home-health and nursing home assistance care in the form of nursing, physical therapy, etc. This unit was previously owned by a major nursing home chain but now is a stand alone business. Profitability is slowly coming about. LUK recently made some management changes to push through more restructuring.

10. Equity Oil – is a company that has been in the energy business for many decades, and LUK owns a piece. Company was acquired by Whiting Petroleum last year. I assume LUK still maintains their ownership interest.

11. Wiltel Communications – is right now the biggest segment of LUK with $1.5 billion in revenues in 2004. In the fourth quarter of 2002, Leucadia acquired common stock in Williams Communications (now WilTel) under its Chapter 11 restructuring plan. In 2003, Leucadia purchased the rest of it, making WilTel a wholly owned subsidiary of Leucadia. Leucadia’s all-in cost was about $780 million. There are MANY skeptics on this deal and is a large reason the stock has been weighed down. LUK is certainly consolidating the industry. Since they did the Wiltel deal, LUK has added 2 more parts – the first was bankrupt ATX Communications ($250 million in revenues for $25 million) and then most recently they announced a deal to buy (bankrupt) VarTec (about $600-800 million in revenues for about $60 million). If you use the interstate ‘811’ when making long-distance calls, then you are using VarTec. LUK paid about $60 million for VarTec and about $25 million for ATX. It is probably safe to assume that VarTec and ATX’s ‘traffic’ will migrate through Wiltel lines. I will not even pretend to know what is going to happen in the telecom space. However, LUK has experience in this business – they have done several different smaller telecom deals over the years. A recent report published by Price Waterhouse Coopers believes spending on streaming media from users of wireless and broadband will rise from $11.4 billion during 2004 to approximately $73 billion by 2009. If those numbers are even close, then I think LUK’s Wiltel position will prove quite smart.

12. Berkadia (Finova) – is a joint venture between Buffett and Leucadia. Finova is a failed financial lender. Buffett provided the cash and LUK does the leg work. LUK has received back around $ 90 million so far, with perhaps more to come. For example, one area where Finova had a big commitment was in the airplane business. As you can imagine, a lot of deals that went bad by Finova, which in turn meant taking back airplanes. These planes are in turn either sold or leased out. There is some indication (earlier than scheduled debt paybacks) that things are turning out better than hoped. As the name Berkadia implies, perhaps there is more to this relationship?

13. LUK has several different investments in funds: an investment in Jeffries Partners fund with a value of $116 million, another fund called Eagle Rock with a value of $60 million, and a venture fund for overseas stocks in INTL/International of about $75 million. LUK recently ended their venture with Pershing Square Partners, a hedge fund.

14. LUK has invested about $15 million (about 15%) in IAAC Holdings (IAAC), a small brokerage firm in Florida that specializes in making markets in foreign emerging stocks, and also has a growth and emerging market fund that LUK has invested $75 million.

15. Jordan Industries - LUK owns about 10%, and also has more coming in the form of loans made to the parent (for about $35 million). Also noteworthy is that in the arena of trading securities, LUK had about $140 million in trading gains in 2004 alone, and Cummings & Steinberg specifically credit J. Jordan for much of this.

16. Conwed Industries – makes plastic netting that you see around highway/construction sites. Plastic fencing, bird nets, sod nets, etc. Last year they added NSW Industries. NSW operates in the same business (netting) but specializes in the drainage and erosion areas.

Revenue breakdown for the most recent full year of 2004

Telecom $ 1.5 billion
Vyvx $123 million
HealthCare $258 million
Manufacturing $ 65 million
Real Estate/Investment/gains $ 63 million
Banking $ 30 million
Corporate $180 million
Other $ 40 million

RISKS

Leucadia confronts several important risks:

1. The loss of key WilTel client SBC. In effect, I am assuming that Leucadia's management will find a way to recover their large capital investment in WilTel by 2009. If they can't, these assets must be written down to reflect vastly reduced cash-flow earning power.

2. Leucadia's balance sheet recognizes substantial operating-loss carryforwards, which I assume it can use to offset tax payments. If Leucadia can't generate sufficient earnings, or regulators prevent restructuring designed to utilize these deferred tax assets in other businesses, then that impacts future profitability.

3. Leucadia faces increasing competition for acquisitions from the explosive growth in private equity funds, which have pressured returns. Cumming and Steinberg note the competition from “35-year-old hedge fund managers — private equity firms who have never known a bear market — and other investors willing to invest at high prices in risky assets with seemingly cheap money.” They call them “unguided optimists.”

IN SUMMARY

In their own words:

"We concentrate on return on investment and cash flow to build long-term shareholder value, rather than emphasizing volume or market share. Additionally, we continuously evaluate the retention and disposition of our existing operations and investigate possible acquisitions of new businesses in order to maximize shareholder value. In identifying possible acquisitions, we tend to seek assets and companies that are troubled or out of favor and, as a result, are selling substantially below the values we believe to be present."

Catalyst