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Jefferies: Possible Postscript

by Jeffrey Bronchick, CFA on November 15, 2012

Funny things often happen on the way to the bank. It is also fair to say that sometimes you never reach the bank, or you end up taking a cab when you thought you were walking.

Where this fits with our investment in Jefferies (JEF) remains somewhat unclear, but it may be helpful for the new reader to refer to our previous writing to get up to speed.  

Now that you are with us, here are some questions to be pondered: Is JEF merging with Leucadia (LUK) a good idea for JEF shareholders? Is the price fair? Does it suggest something about the company’s “model” and the world in which we live that implies more than is evident in a simple deal? And just how long can a small cap portfolio continue to own the stock given the pro forma $8 billion-ish market cap?

 Here are answers to (some of) those questions in bullet-point form:

  • LUK is an investment vehicle run by two 70-ish gentlemen who have put together a smashing long-term record, but whose results are unduly skewed positively by a VERY low starting point. That said, they are classic, smart value guys who have built a well-regarded team around them over the years. Pre-deal, the stock sold roughly at book value with value derived from the standard LUK mishmash of wholly-owned companies, partial positions like JEF, and what I would call a collection of “investment peccadillos.” They rarely talk to outside investors and they write snarky “Letters from Management.” What’s not to love? 
  • For over a decade LUK invested with JEF, then in JEF, and now want to own it. This is the poison they know and there are likely to be few surprises and few changes in how JEF is run. I do wonder about JEF’s compensation practices, as equity was liberally issued to create some sort of “team feeling” and some of that will be lost if LUK stock is used.
  • This deal clearly benefits LUK more than JEF, both on a strategic and financial basis. While “stealing” JEF might be a stretch, it faces that direction. LUK is using equity with its stock trading at book value to buy JEF at essentially book value, and I would strongly argue that JEF is a higher risk/higher return company with a bigger growth story. But if it is the risk that concerns an investor, one can “position weight” JEF in a portfolio to account for it— just like we did. We don’t need a LUK deal to do it for us. Wall Street “consensus” suggests that corporate finance and fixed income trading are dead money for this generation. After all, strategic geniuses like UBS management have declared it thus. An alternative competing hypothesis is that benefits are accruing to those that remain in the business. A world with fluctuating interest rates and the resulting “activity” that follows is the historical norm rather than the exception; globalization continues with concurrent deal and trading activity to follow; and US corporate finance should follow stronger US economic growth, whenever that happens. Ergo, the “grand experiment” conducted by JEF CEO Jeff Handler of hiring nearly everyone leaving Goldman, JP Morgan, and Merrill Lynch to build a “classic” Wall Street firm—if bought at book value—presents an incredibly interesting risk/reward scenario.
  • “Consensus” also suggests that JEF needs to be bigger and needs more capital to “compete.” To reiterate, JEF is not a bank and it is not SIFI (Systemically Important Financial Institution) and thus is presently not subject to specific capital ratio requirements, although the balance sheet is effectively marked to market. Does LUK “provide” more capital to JEF as a wholly-owned subsidiary? Interestingly, it was LUK’s debt that ticked up upon the announcement of the deal. JEF’s creditors will not acquire the right to go after the rest of the LUK asset base and I am sure that LUK will not enable that feature in the future. While it is true that LUK will think longer and harder in the dark and cold night about whether to extend further capital to JEF in the midst of a crisis—given 100% ownership versus 34% ownership—this contractually will remain “moral suasion.” LUK was always going to get the first call in the case of a liquidity emergency at JEF; the deal just formalizes that.
  • Yes, LUK has a $1.4 billion deferred tax asset, but this doesn’t drive the deal. JEF is running at roughly a $300 million annual pretax income rate. Assume 80% US-based earnings for JEF and a 35% tax rate, and you add 1% to the growth rate of Newco book value thanks to the shield.
  • Having spent several thousand hours with Berkshire Hathaway, Loews, a number of Liberty entities, and dozens of other “smart guys, sum of the parts, book value growth stories,” (not to mention 15 years of LUK financial reporting) I expect Newco is going to be a financial reporting mess that is not conducive to a big premium to book value. JEF will get consolidated as opposed to having a nice, tidy publically traded value, and thus LUK’s GAAP reporting will be a mess. I personally think it is helpful if management lays it out VERY simply for the global base of potential shareholders (once I have a full position), but if there is messiness, particularly right now, that presents an opportunity. Note to management: hire someone from Pershing Square who does those 200 slide Power Points.

To conclude 72 hours into the deal, the pro-forma book value for Newco is $24.67. LUK now trades under $21. How fast will book value grow? Do you trust the capital allocation strategy for a company that is 33% Jefferies and 2/3 Oldco Leucadia? I don’t like the deal per se, but I could see myself being interested in the Newco.

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