Fiscal Cliff Doesn't Matter

So the markets now are driven by the fiscal cliff.  What will happen?  If they don't do something, the markets will plunge.  If they come to some sort of agreement, the Dow would be up 1,000 points. 

Nobody wants to be long on a failure to come up with a solution, and nobody wants to miss the boat on a 1,000 point Dow rally.   OK, 1,000 points is not much.  Maybe I should say 2,000 points.

In any case, this reminds me of a recent Howard Marks interview where he talked about the European situation.  He says there are three things he can say for certain about the situation:

1. He doesn't know what will happen in Europe
2. Nobody knows what is going to happen in Europe
3. If you ask an expert what they think will happen and take their advice, it would be a mistake.

So to apply this to the current situation:

1. I have no idea what will happen in Washington with the fiscal cliff
2. Nobody knows what will happen in Washington with the fiscal cliff
3. If you ask an expert what they think will happen and take their advice, you are making a mistake.

Of course, ths fiscal cliff matters in many ways.  But what I am talking about is within the context of investing for the long term.

If you believe that the U.S. and the world is drowning in debt and the Fed is out of silver bullets and the economy is peaking out and won't recover for years to come, then you shouldn't be invested in the stock market fiscal cliff or not.

If you believe that the U.S. and the world will eventually recover and be fine (maybe not as 'hot' as back in 2007, but some growth and stability), then you should be invested in businesses you like at reasonable prices fiscal cliff or not.

Here are some things you might want to think about:

• Selling stocks now because you are worried about the fiscal cliff is a mistake.  This is not a rational decision; it is driven by emotion (fear).  And emotions should never drive investment decisions.
• Buying stocks now because you think the fiscal cliff will be resolved is a mistake.  This is not investing; that's speculating.  Nobody knows what will happen with the fiscal cliff.  Betting on single event outcomes is speculating, not investing.  (One should invest in businesses or situations because they are priced right etc...)  Betting on single outcomes if the odds are reasonably calculable and the stock is priced or mispriced accordingly, that's different.
• Shorting stocks or hedging against the fiscal cliff is also a mistake as it is not too different from selling your stocks out of fear (although hedging may be tax efficient as you don't have to realize capital gains like you do when you sell out longs).  This may seem 'prudent' and responsible, but it's still speculating.  Nobody ever knows when the markets go up or down.  Hedging or buying puts in anticipation of a sell-off, to me, seems more like speculating than rational investment behavior.  

...which leads me to the something that I thought about that is related to Buffett's frequent comments about not selling a good business you own just because of what is in the headlines.

Why People Make Money in Real Estate
OK, so this title seems odd given that we are trying to recover from the biggest real estate bubble/collapse in history.  Real estate has a history of big booms and busts, and there have been big real estate bankruptcies (Reichmann, Trump etc...) not to mention the disaster that is Japan and the most recent U.S. real estate bust.

But on the other hand, why is it that so often the biggest gain that many people have ever made in their lives have been in real estate?   (I know tons have been lost in real estate too)

Just thinking about family, relatives and friends (very small sample size, but...), it seems that the biggest winner has been their house or some other property, and not a stock.  I don't live in Omaha so I don't know anyone in person that has owned Berkshire Hathaway since the 1970s.

I have always noticed this and thought about it but never really expressed it out loud. 

There are a lot of reasons for this, of course.  Your primary residence is a big asset; if there is inflation, of course it's going to be your biggest winner.  Tax-incentivized leverage also helps.  Nobody is going to take out a 20% down loan and spend a good portion of their disposable income paying interest/principle on a stock investment.

But for me, what I often thought about was the illiquidity of the house.  This is why individuals were able to do so well in real estate over time while they get clobbered in stocks. 

Check this out. Compared to stocks, in real estate:

• You can't get a quote on your house every day.  You can't look up the price of your house on Yahoo Finance.  OK, you can Zillow it, but it's not the same as seeing a firm bid and offer that is hittable instantly.
• The evening news doesn't start by telling you that your house price was marked down by 2% that day due to some event that happened in Europe, or because of what some politician in Washington said.
• You can't push some buttons on your iPhone and liquidate your house in less than five seconds.
• Pundits are not on TV, the internet or in magazines telling you every minute of the day to sell your house and buy the one across the street because it will go up more, or tell you to sell your house because it will go down because of some fiscal cliff, canyon, valley or whatever...
• People don't talk about how much their house went up at cocktail parties (well, this did happen during the housing bubble) and tell you to buy a house next to theirs (unless you are so wealthy that you buy and sell homes like people buy and sell stocks).
• Financial Advisors don't tell you to sell some of your house and put more in bonds as the economic outlook isn't as good as it was a few months ago.
• People don't pound the table and tell you to sell your house because it has been raining in your neighborhood for the last five out of seven days.
• People don't tell you to sell your house because it is worth 10% less than it was last week and it may go down more.  Or because your house value, as of yesterday, is now below the 200-day moving average.
• You don't have some crazy guy on CNBC every day waving his arms around spitting into the camera telling you to sell your house and buy the one across the street one day and then doing the exact opposite the very next day.  But I already said this in bullet point three, but I thought it's important enough to say it again.
• Most people can only afford to own one or two houses at a time, so each purchase is done very, very carefully (like the Buffett 20-hole punchcard*; only most people have a 2-hole punchcard).  They spend days, weeks, months and even years looking and researching their house before they buy as it is a huge commitment (unlike people buying 100 shares "for fun" just in case someone's 'tip' proves correct.  Many people can afford to do this very often; so often as to build up a really crappy portfolio of stocks they know nothing about).

Anyway, we can go on and on with this list.  Surely, there are some negatives too.

But my point is that many people have done really well in real estate over a long period of time, but it's not so common to hear the same about stocks.  And that's because of the curse of liquidity.  I think liquidity is actually a good thing, of course.  But it can have it's drawbacks.  When it's right there at your fingertips, it's hard not to want to do something. And everyone around you including the professionals are constantly telling you to do something!

I was stunned when a "professional" investor on CNBC was telling people with a straight face that you can't ignore this stuff (fiscal cliff); this stuff is very important and it will move markets.   Well, if you are a professional fund manager being evaluated on a daily, weekly and monthly basis, I guess he is right; you can't ignore this stuff.  But if he thinks people can trade in and out based on what is going on in Washington, I think he's nuts.

Anyway, with the fiscal cliff approaching, everybody talks about what to do with the stock portfolios, but nobody ever talks about what to do with their houses (OK, I admit some people must be thinking about it and I'm sure personal finance magazines, websites and blogs probably do consider that too as they would make good 'filler' content).

But no real rational person is going to buy or sell their house on this issue.  And that's what Buffett keeps saying about stocks.  You have to look at it like a business (or a house).

What businesses are thinking about selling out because of fears of the fiscal cliff?  If you own and run a profitable restaurant at a great location, why would you sell just because of this near term issue?   If you love your house, why would you sell just because of this?

So What's Going to Happen?
Well, I said I have no idea and nobody really knows.  Anyone who claims to know has something to sell you.

Having said that, this is a blog and we are allowed to say anything we want.  So if I had to guess, my guess is that they go to the very end of the line, the market plunges, people freak out and they come to some sort of kick-the-can-down-the-road agreement.

You know at the end of the day they will come to some agreement.  The only question is when it will happen and how far the market has to go down to convince Washington that something has to happen.

It's just like what happened with TARP.  First, they said "no", the market plunged 700+ points (or whatever it was) and they all suddenly rushed in, "where do I sign?!".

This doesn't mean that's the way it's going to go this time around.  It's just my guess.

To do anything based on that scenario (buy puts, sell out with the intent of getting back in cheaper later etc...) is pure speculation so don't do it. 

Ignore all this noise.


*Buffett's 20-hole Punchcard
Value investors know what this is, but I realize this blog is read by a wide range of people.  For those who don't know what the 20-hole punchcard idea is, it's Buffett's way of telling students to choose investments carefully.  In a lifetime, people will find only very few really good ideas. And having just a few very good ideas is going to be enough to get very rich.

So instead of just buying stocks left and right promiscuously (as many novices tend to do), do solid research, look hard and look for only the best ideas.  When that is found, then invest big in the idea and try to go on to the next one.   And invest as if you only have 20 times you are allowed to invest.  Once you invest in one thing, one hole in the punchcard will be punched out. 

This will make you think very carefully about what you buy as you can't afford to make too many mistakes.

This also reminds me of Peter Lynch's comment that he is baffled that people spend more time researching and shopping for a refridgerator or car than they do a stock even when their stock investment is much larger than their fridge or car.

Going back to my house argument, if people did as much work on stocks they buy as they did shopping for a house, more people would do better.

Even if they did, though, since this is not Lake Wobegan, we can't all become better than average investors.

Leucadia-Jeffries Merger Loose Ends

So after posting my initial look at the merger, a couple of points have been raised.  Or I should say one was raised (in the comments section in the previous post) and that lead to another point.

One is the issue of dilution.  I said that this merger would have a 4.7% or so dilutive effect at the prices on the LUK presentation.  This is correct on a pro-forma, post-merger stated book value basis. 

But someone pointed out correctly that the book value of JEF in that calculation uses LUK's acquisition price for JEF and not the book value of JEF; the post-merger book value of LUK would include the premium to book value that LUK pays for JEF (which would end up as goodwill).

Is this fair?  I will get to that in a moment.  I don't think it's a bad analysis because we still look at Berkshire Hathaway, for example, using book value per share even after the Burlington Northern acquisition (we don't adjust the BNI value down to the pre-merger book value of BNI).   Book value is only a rough guide and there are other models to look at BRK, but still, BPS is an important measure for BRK's value; important enough for Buffett to use 1.1x book as a buyback level.

But anyway, when we look at financials, we do tend to look at if it is dilutive or accretive to book, and we do often look at stated book value of the respective firms.

"Real" Dilution

OK, so let's recalculate the dilution to LUK shareholders of this deal excluding the goodwill that may arise from it.  In order to do that, I will use JEF's current book value instead of LUK's purchase price of JEF, add it to LUK's current book value and get a post-merger BPS.

Here is the page from the presentation.  If you can't see it, it's page 32 of the merger presentation available at LUK's website.

 

So instead of using the LUK share price times 0.81 x JEF shares outstanding to calculate JEF's adjusted book value, let's just use their stated book value.

According to JEF's latest 10Q, JEF's adjusted shareholders' equity is $3,515 million.  So let's use that instead of the $3,782.1 million adjusted JEF equity value.  To calculate this quickly, all we need to do is adjust the combined book value for all of LUK down by the difference which is $267 million ($3,782 mn - $3,515).

The adjusted combined book value for LUK in the above table is $9,325 million.  Deduct $267 million from that and you get $9,058 million.  Divide that by the adjusted LUK shares outstanding after the merger of 377.7 million and you get a post deal book value per share of $23.98/share.

According to the above table, LUK's current BPS (less Crimson) is $25.91/share.  That means that excluding the goodwill from the deal, dilution to LUK shareholders is close to 7.5%.

So that looks like a lot of dilution!

Obviously, if you think JEF is worth only book value, then you would be pretty unhappy with this deal.  Not good.  

But wait a second.  All the time we have been valuing LUK, we have marked the LUK holdings to market.  When JEF was trading far above book value, we didn't adjust book downward to JEF's stated book value.  We marked the position to market.

So in that sense, we don't need to force the value of JEF to book value just because they own all of it.  Why mark to market when partially owned and then force a mark to book value (and exclude acquisition goodwill) when wholly owned?  That is not consistent. 

Of course, recently, JEF has been trading lower and LUK's deal has pushed the stock price up so one can argue that appreciation in price is artificial.    But let's take a closer look at this and see what JEF might be worth (or at least what maybe the LUK folks feel it's worth).

JEF Value

When LUK first bought into JEF in April of 2008, the deal was priced on April 18. The closing price of JEF on that day was $14.98/share.  As of the end of the most recent quarter at the time, JEF's book value per share was $13.03 and the adjusted BPS was $12.10 (adjusted for RSU's).  

So that was done at 1.15x BPS and 1.24x adjusted BPS.  Granted, at the time, LUK's share price was $53.36/share against a BPS at 2007 year-end of $25.03/share.  So they issued stock at 2x book to buy something at 1.2x book.  Nice trade.

But LUK has also bought stock in the open market over time.  They have said previously that JEF is a good buy at close to book value.

So JEF has been on the LUK books since 2008.

I just jotted down the BPS, adjusted BPS and stock price of JEF since 2009 to see how JEF has been valued in the market.  I figured 2008/2009 stock price would be depressed due to the financial crisis and not really that representative and anything before that of course may be even more unrealistic as financials were valued pretty high pre-crisis.

Anyway here is the data:



JEF Valuation



Common BPS is the GAAP BPS that most people see.   This is the figure people see when they think the LUK deal was done at below book value.  The adjusted BPS is adjusted for RSU's and is more accurate since it is fully diluted for RSU outstanding.


Anyway, since the first quarter of 2009 (the panic low during the crisis), JEF has traded at an average of 1.56x adjusted book value per share.  1.56x is not a bad benchmark as it is mostly a post-crisis valuation and it includes the MF Global contagion/JEF panic in late 2011.

If you exclude the early 2009 panic low and the MF Global panic and only include the quarters 2Q2009 through 2Q2011 (labeled "average*" in the above table), JEF traded at 1.96x adjusted book value per share.

So that is sort of the market evaluation of the JEF business model post-crisis excluding the effects of the Euro-meltdown/MF Global panic. 

JEF has not recovered from that, and the market is now undergoing a fiscal cliff panic.  So excluding these effects, JEF may be reasonably be valued at 1.5-2.0x BPS.

Going Back to the Dilution Issue
So the first point would be, if we didn't adjust downwards the value of JEF to it's stated book (when it traded above book) and we calculated LUK's book value using the mark-to-market value of JEF when it was partially owned, then it doesn't make sense that we do so now post merger just because this "goodwill" is artificial. 

The part that is artificial is that LUK's acquisition did push up the price of JEF; it doesn't reflect pre-merger mark-to-market of JEF itself.   But it didn't do so beyond the previous range of where JEF has traded in the recent past.

With LUK trading at around $21/share now, that makes the deal worth $16.35 per JEF share. Since the adjusted BPS of JEF is $15.63/share, that's a 4.6% premium, not much.   Even at the presentation value for JEF of $17/share (when LUK was at $21.80), that's a 9% premium, or a value of 1.09x book value for JEF; not an unreasonable valuation at all given it's recent trading history.

You can argue that this very deal will reduce or eliminate the liquidity concern that arose about JEF after the collapse of MF Global; there is no reason why after this deal that JEF should be worth less than book.  As an independent, there was always a concern of an MF Global-type run triggered by a European collapse or some other event.

So I would be inclined to say that the LUK presentation post-merger valuation (including goodwill) is fine for looking at dilution.  I think it's important for shareholders to understand all of this, though, and realize that there is another way too look at it (7.5% dilution).

And By the Way
Also, there is a circular aspect to this dilution calculation and what LUK is trading at now versus a post-merger BPS.

Since the deal is not fixed in terms of price (no price floor/collar or anything like that), we don't really know what the dilution is going to be.

Calculating the above LUK presentation dilution (using LUK acquisition price as JEF adjusted equity), the dilution changes as follows at various price levels of LUK:

LUK Price           post-deal BPS        dilution
$25                       $26.21                   1.1% (accretive)
$24                       $25.73                   -0.7%
$23                       $25.25                   -2.6%
$21.80                  $24.68                   -4.8%  (price on presentation)
$21                       $24.30                   -6.2%
$20.32                  $23.98                   -7.5%  (price at which deal value is equal to JEF adjusted BPS)

There would be no further dilution under $20.32/LUK share because if the deal price was worth less than adjusted JEF BPS, there would be a bargain purchase gain, and JEF will be booked at the original JEF book value.

There is obviously less dilution the higher the LUK price upon the closing of the deal because the JEF adjusted equity value will include "goodwill"; it will be booked at a higher value on the balance sheet in proportion to how high the LUK stock price is.

With LUK shares trading now at $21/share, the immediate dilution to LUK shareholders (including acquisition goodwill) would be -6.2%, more than the -4.8% calculated according to the presentation (due to the lower LUK price since then).

Post-Deal BPS and LUK Valuation
One other thing is that since the post-deal BPS is dependent on the price of LUK at the closing of the deal, the post-deal BPS on the LUK presentation is not current since the stock price has changed.

I said that the post-deal LUK BPS is $24.69, and if you add back Crimson Wine, then the value is $25.50.   Against that, it looks like LUK, which closed at around $21.00 today is trading at a 17.7% discount to post-deal BPS.

But this post-deal BPS is only good with LUK priced at $21.80.

With LUK trading at $21.00/share, the post-deal BPS is actually $24.30, and with Crimson added back in, that's $25.11.

So the actual discount is 16.4%, not 17.7%.  Not that big a difference.  It's still pretty cheap.

Anyway, here is a table that shows how the discount changes according to LUK's price:

LUK                          post-deal                     
price                          LUK BPS                  discount
25                              27.02                           -7.5%
24                              26.54                           -9.6%
23                              26.06                         -11.7%
21.80                         25.50                         -14.5%
21                              25.11                         -16.4%
20.3                           24.79                         -18.1% 

The above post-deal BPS includes Crimson Wine to make it comparable to the current price.
Below around $20.30/LUK share, JEF would be valued below book, so there would be a floor there because JEF would be recorded at their own book value with the difference recorded as a bargain purchase gain.

Of course the other way to look at the post-deal BPS is to use JEF's current book value instead of LUK's purchase price.  This would not change because of changes in the LUK stock price.

From the above calculation, this would be around $24.00/share.  So even with JEF booked at the old book value and not including goodwill that may arise, LUK's post-deal BPS would be $24.00/share.  Adding back Crimson Wine's $0.81/share value and you get $24.81/share.  With LUK trading at $21/share, that's a 15.4% discount.  Not bad.

LUK is Still Cheap
So even with the above adjustments and high dilution due to a lower LUK stock price, LUK stock is still pretty cheap, and even if with no acquisition goodwill, LUK is trading at a 15% discount to the post-deal BPS. 

So Why'd They Do It?
If you asked them why they did this deal despite the dilution, I bet they would say that they think that the deal is accretive to LUK on an intrinsic value basis.  They will tell you that they are not too concerned with conventional accounting, GAAP book values and things like that.

They did say that they really like JEF at close to book value, which means they think it's worth much more.  They were comfortable owning this at 1.5x-2.0x book for much of the post-crisis period.

If you think JEF is worth 1.5x book, for example, then this deal may not be dilutive at all.  The trick is figuring out what LUK is worth, of course.

Dilution Based on Instrinsic Value
Just for fun, I will fill in some of the above tables and see what the dilution would be if JEF was in fact worth 1.5x book value.  I know some of you will think I am reaching here and trying too hard to make this deal look reasonable.  But that's OK.  I am just looking at this from different angles and I'm not trying to argue one way or the other.

Using the LUK presentation table, let's just wave a magic wand and change the number in the adjusted JEF equity value to 1.5x JEF adjusted book value.  Adjusted book value of JEF was $3,515 million at 3Q-end, so 1.5x that is $5,273 million.

Now the post-merger LUK BPS comes to $28.63/share.  The current LUK BPS (excluding Crimson) is $25.91/share, so now the deal is suddenly 11% accretive.

And then adding back the value of Crimson, LUK BPS would be $29.44, so that would make LUK at $21/share trading at a 29% discount!

OK.  So there are problems here. I used an intrinsic value of JEF against the book value of LUK.  To be totally fair, you have to look at intrinsic value versus intrinsic value.  But for me, since I usually value LUK at book value (adjusted for some things), it is not too far off.

This is just an illustration of why this deal is not as simple as "it's 8% dilutive so it's horrible!".  Technically it's dilutive, but there is more to the story than that.  And that's what I tried to illustrate with this example.  I don't mean to say that this deal is 11% accretive, or that LUK is now trading at a 30% discount.

I just point out that it can be seen this way if one thinks JEF is reasonable worth 1.5x book value.  And that's not a stretch at all, again, if you think that this deal will reduce the risk of an MF Global-type run, or someone Egan-Jonesing them again.

Of course, if you think JEF is worth 1.5x book, then JEF has been a great value in the past year or so.  Well, maybe that's why LUK is buying them out.


Can We Really Get to 1.5x Book for JEF? 
One last thought.  I think the smaller investment banks do tend to trade at higher multiples than the large ones.  Recent history of JEF trading when not being Egan-Jones-ed tends to support higher valuation for a company like JEF.

Many of us make fun of investment bankers all the time, but I do like to read merger proxies as they do tend to have valuation comps that can be interesting (and silly at times too).  So we may get more insight into valuation for JEF.

But we may be able to get 1.5x valuation on our own.  We know that the LUK folks want to get 15% pretax return (or much better).  So let's use a pretax 15% return.   Since I already did the work, we can use book value growth plus dividends as a proxy for long term return-on-equity (it will serve as a sort of comprehensive return on equity over time)

From the other post, here is the growth in book (plus dividends) of JEF over time (annualized):

                            Growth in BPS+DVD            Pretax Comprehensive Income
1996 - 2011         +15.4%                                 +25.7%
1999 - 2011         +13.9%                                 +23.2%
2007 - 2011           +5.6%                                 +  9.3%

So since 1996, JEF grew book value including dividends at a rate of +15.4%.  On a pretax basis (using a 40% tax rate), that's +25.7%/year.

From the 1999 peak, they earned 23.2%/year pretax.

If they need 15% pretax returns, JEF can be worth 1.5x book (at 1.5x book, this 23.2% pretax return turns into 15%).

Now this too is not so simple.  Yes, the previous ten to twelve years has not been the greatest time for financials but there is no guarantee that the next ten or twenty will be as good for JEF.

This, again, is just to get my arms around a 1.5x valuation.  Is it reasonable or not?

I don't do this to convince anyone either way; I just present the facts and analysis as food for thought.

Conclusion
So I fine tuned some stuff from my other post here and there were some adjustment/changes that had to be made, but I don't think the conclusion changes much.

The deal is dilutive looking at it conventionally. But who said these guys are conventional?

For me what's important is that I do like the people involved on both sides, the deal is not ridiculous (this is not Time Warner / AOL) and in fact might be a great deal depending on how you look at it (1.5x book value scenario), and the LUK stock is currently pretty cheap either way.

The 1.5x book value scenario and analysis is just illustrative and shows that this can be a a totally reasonable deal depending on what you think JEF is worth.  1.5x is just a figure I plucked out of the air as it seemed to be at the lower end of the range of JEF's stock excluding periods of panic (and it's the average since 2009).

I know many people assume investment banking is dead and that's why JEF is trading cheap.  But I tend to disagree with that.  I don't think investment banking is dead at all; I do think it will come back.  And I think JEF was trading cheap mostly for fear of another MF Global-like run.  This is clear from the valuation pattern through 2011; it traded well until MF Global collapsed and a bad (and wrong) report about JEF came out.

Of course, if you think investment banking is dead and the low valuation is the correct valuation, then obviously we will disagree on what we think about LUK going forward, and about this deal.

You can easily make a similar but more moderate argument using 1.1x book, 1.2x book etc.

So my opinion remains the same.  Good deal, but of course it would've been better if it wasn't dilutive, but then again, from a value gained perspective, it may not be as dilutive as it at first appears.

Also, this is not a complicated deal at all.  It's pretty simple.  But there are a lot of numbers involved in the stuff I wrote, so I may have missed something (hopefully nothing big!).  If so, I apologize in advance.

In any case, we all have to do our own work so do your own work and make up your own mind!

Leucadia-Jefferies Merger

So this is what it comes down to.  Leucadia (LUK) buys Jefferies (JEF) and solves some problems with one deal:

• Succession:  since Handler will become CEO of the post-merger Leucadia, succession is no longer an issue.  Handler is well regarded and is known to be a very solid, conservative manager.  I have no problem with Handler at all.
• JEF Liquidity Problem:  Actually, I don't think JEF has a liquidity problem and I don't think they had one last year.  But clients and markets have gotten much flakier post-crisis, and ratings agencies seem trigger-happy (and sloppy), so there was a risk that JEF had to manage over-conservatively to compensate for this.  In fact, I think most of the industry is in this situation, and that's why I think the JPM investment bank has higher ROE than the independents (GS, MS etc...).  As long as JEF resides inside of LUK and LUK has plenty of liquidity, this will reduce the risk of "runs" and impact of bad ratings agency opinions. (The fact that LUK is junk rated doesn't matter as long as they have the cash/liquidity)
• Deferred Tax Assets (DTA):  I didn't do the math on this yet, but this really accelerates the realization of the DTA since JEF earns $300-400 mn/year in operating earnings.  Whatever discount factor we applied to the DTA on the balance sheet can be reduced as it will now be realized much more quickly than before.  I may take a look at that later (but maybe not).

Anyway, here is a presentation on the merger from LUK's website:

Leucadia-Jefferies Merger Presentation

Here are some quick highlights:

The New LUK (no pun intended)
This is what LUK will look like after the merger.





44% of the value (at book) of LUK will be in JEF.  This does change materially the nature of this business.  I know some folks who are fans of BRK, L, LUK and other of these value investing conglomerates don't like investment banks.  So just because of that, I can see why many LUK shareholders are not happy with this deal and would sell their shares.

I am not allergic to investment banks as readers here know.   So I have no problem. 

Past Performance
Here is the long term performance of both of these entities over the long term. 

 

Since both of these entities are more or less trading near book, stock price is a reasonable proxy of performance (as opposed to looking at something that might have been grossly undervalued at the beginning of the period and way overvalued at the end of the period, like looking at the S&P 500 index performance between 1982 and 2000, for example)

JEF Long Term Performance versus Peers



Of course, one can argue, "but they needed to be bailed out during the crisis...".  They did lose money during the crisis and did get an equity infusion from LUK.  This is true.  But the fact is that they were able to raise the needed capital, and their business model was sound.  Of course it will bother many that they actually needed to raise capital, regardless of how well it was done.  That is enough for some people to not want to be involved in this kind of business.  Fair enough.

BPS Growth Versus the Usual Suspects
So just how good is this guy Handler, though?  He became CEO in 2000/2001 but since we have data for JEF going back to 1996, let's look at how book value per share has grown over that time versus the S&P 500 index, Berkshire Hathaway (BRK) and Leucadia (LUK) itself.  I just put some charts together quickly to take a look.  These are not from the merger presentation.

This chart is the BPS growth (indexed to 100) of the various companies since 1996 (December 1996 - December 2011).  The S&P 500 index figure is just the total return of the index.

 

It is remarkable how well JEF has done over this time period.  Keep in mind that this chart understates returns because it doesn't include the ITG spinoff from JEF back in 1999.

Judging from this, JEF has done way better than even LUK and BRK.    So it makes sense that this is a sort of reverse takeover of LUK by Handler!

Just to make sure this isn't due coincidentally to two lucky data points, I looked at the same figures starting at the end of 1999 which was the peak of the bubble in the stock market (at least in year-end terms).  Here is how the usual suspects have grown their BPS over that time:

Again, JEF outdoes everyone, including BRK.

I also did the same for the period 2007-2011, but didn't bother with creating a chart.

Here is a table that summarizes the above stuff:

BPS Growth Including Dividends (S&P 500 index is just total return), annualized

Period:                 JEF               BRK          LUK         S&P 500
1996 - 2011:        +15.4%         +11.7%       +9.9%       +5.5%
1999 - 2011:        +13.9%           +8.4%     +11.8%       +0.6%
2007 - 2011:         + 5.6%           +6.4%       +0.2%        -1.6%



 

It's pretty impressive.  I didn't think I would get this result before I put these charts together.  But there it is.

I read somewhere that LUK is no BRK as BRK would never do such a deal as this or some such.  Well, maybe LUK is better than BRK judging from these figures!

Keep in mind that this JEF performance was accomplished in a pretty horrible environment with two big bear markets, financial crisis etc. in an industry that was the epicenter of the crisis.   And of course it includes the loss and equity infusion during the financial crisis.  You will notice that this was done with barely visible damage.

Contrast that with the real bailouts (as opposed to JEF's proactive, preemptive capital raising) of say, Citigroup, Bank of America and AIG.  The book value growth graphs and stock price charts of those would show a very different picture.

Anyway, with JEF, what's not to like?  (unless you are bancophobic)


After the Merger: Different Business

So here's an interesting slide from the presentation.  They actually set parameters for the new LUK.

After the merger, the largest equity investment (excluding JEF) will be no greater than 20% of book value, and no other investment can be greater than 10% of book value at the time of investment.  Also, there is a new leverage limit (as shown above).

 

This may be due partly to make sure no post Cumming/Steinberg CEO blows LUK up, and partly to stabilize the non-JEF part of LUK as liquidity may be needed to support JEF in times of stress.   

 

In a sense, this may be the opposite of the Berkshire Hathaway (BRK) model:  BRK owns insurance companies that provide float that BRK can use to make investments while LUK may now have to hold excess cash/liquidity at low returns as reserve in case JEF needs it.

 

But there would be some advantages from this in terms of capital efficiency that is similar to BRK.  When JEF has business with decent return potential, LUK can inject more capital.  When the opposite is true, they can transfer capital out of JEF into the non-JEF part of LUK.  Of course, this can't be done without the approval of regulators as capital regulations are very strict when it comes to transferring cash in and out of a regulated subsidiary to and from a non-regulated parent.  But this is true with BRK and the heavily regulated insurance companies too.

 

It is capital efficient in the sense that if JEF was independent and they wanted to maximize capital efficiency, they may buy back a ton of stock during slow times and then have to raise equity capital when things start to pick up.  This can be costly and very inefficient, not to mention the problem of having to raise capital possibly during times of crisis when an independent JEF's stock price may get really cheap (and therefore expensive to raise capital). 

 

You can get a sense of this capital inefficiency of independents when you listen to Goldman Sachs conference calls.  On the one hand, they want to buy back a ton of stock as they are underutilizing their capital.  But on the other hand, they don't want to be left short of capital when things start moving, the markets come back and business picks up again.  For GS, it's pay dividends and buy back stock, or sit on their capital and wait.

 

With a JEF/LUK combination, there would be more choices to choose from.  There are more levers to pull in terms of optimizing capital efficiency. 

This added flexibility really does enhance the opportunity for value creation of the combined entity.

 

LUK is Cheap

Anyway, moving on.  So what happens to LUK post-merger?  If you own LUK stock now, what is it going to be worth after the merger?

 

After the deal (which includes the pre-merger LUK spinning off Crimson Wine), LUK will have total assets of $42.1 billion, total shareholders equity of $9.3 billion and a book value per share of $24.69/share.

 

The stock closed today at $20.75.  The above $24.59 post-merger BPS excludes Crimson Wine, which will be spun off before the merger.  That is worth $0.81/share.  I have no idea what Crimson Wine will trade at after the spinoff, but assuming it trades at $0.81/share, the post merger value of LUK and Crimson together would be $25.40/share, so LUK is trading at a 18% discount.

 

That's pretty cheap.  But to be fair, so are most other financial companies and after the merger, LUK is going to be half an investment bank.

 

Merger Arb

This is an all stock deal.  JEF shareholders will receive 0.81 shares of LUK and they expect the deal to close in the first quarter of 2013.  Before the deal closes, though, LUK will spin off Crimson Wine, which has a value (at book) of $0.81/LUK share. 

 

The current LUK price is $20.75, and less $0.81/share (Crimson spin), that gives a value of $19.94/share of LUK that JEF holders will receive.  They get 0.81 shares per JEF share, so that's $16.15/share in value to JEF holders.  JEF closed today at $16.00/share, so that's a $0.15 discount.

 

LUK has a dividend of $0.25/share and JEF is $0.30/share (both annualized).  Since there will be only one dividend payment (according to last year's dates for JEF), that's a net dividend of $0.0125 for the long JEF/short LUK position.

With 138 days until March 31, 2013, a $0.15 discount plus $0.0125 net dividend works out to a 2.7% annualized return; not much.

If you are an institutional investor and get cheap leverage and can finance this long/short at 40 bps (Fed+20 bps to finance long, receive Fed-20 bps on short) and can get 6x leverage (15% capital), I guess that works out to 13.8% annualized return (2.7% annualized return less 40 bps financing cost times 6x).

I don't do this sort of thing, usually, so I may have missed something in the above calculation.  It looks pretty tight.  If you can only make 14% with 6x leverage, that's not very exciting.

In any case, this isn't the main point of this post.  

Why All Stock Deal?
Of course the question is going to be, why would LUK issue cheap shares (below book value) to pay for JEF (at book value, or over tangible book).  

The reason they would do this is as a stock transaction is that it would be tax free to JEF shareholders (Richard Handler being one of the large ones) and it will allow JEF shareholders to benefit from the future value creation of the combined entity.

LUK went out of it's way to liquify their portfolio before announcing the deal, so it seems they are more comfortable with the deal with this excess liquidity.  This means that they wouldn't have considered the deal if they were going to issue debt costing 8%, or if they had to use up all of their cash and liquidity to pay for the deal.

OK, Fine. But How Dilutive Is This Deal?
From page 32 of the presentation, we can see that LUK had BPS as of the end of September of $26.71/share.  After the merger, LUK will have BPS of $24.69/share.  Adjusting the first figure for the Crimson Wine spinoff, you get a September-end BPS of $25.90/share.  So that's a $1.21/share dilution to current LUK shareholders.  That's a 4.7% dilution right there.

Is it worth it?  Well, like anything else, you will have plenty of varying opinions.

I think the big thing about this deal is the succession issue.  Richard Handler is a highly regarded CEO and this would seem to be a small price to pay to get this deal done and in such a way that many JEF shareholders will roll into LUK.

Given that Handler helped find some of LUK's investments in the past (Fortescue etc.), he may be instrumental in finding other ideas.  Which leads to the next question:

Potential Conflicts?
Now, I do think this is a great deal and LUK shareholders, unless they are allergic to financials, should be comfortable.  People who hate investment banks and financials in general should probably sell out (maybe at a better price once this cliff nonsense clears).

But having said that, I do wonder about the issue of conflicts here.  LUK was a client of JEF; JEF brought ideas to LUK for them to look at.  I am thinking about the potential conflicts that people raise with Goldman Sachs.  On the one hand, they have investment bankers looking for deals and matching buyers with sellers.  And on the investment side, GS have their own people looking for deals to do too.  When a deal is found, how do you decide if it's OK for GS to go ahead and buy, or do they have to show it to a client that was looking for something like it before doing the deal themselves?

In the case of GS, I guess you can make the case that the private equity funds inside GS operate independently and the CEO doesn't see these deals.   At least there is some sort of Chinese wall there.  (There have always been walls between trading and investment banking even though many seem to believe they don't actually exist.  In my experience, they actually do exist even though it may leak from time to time).

But if Handler is CEO of both JEF the investment bank and LUK the opportunistic value investor where the CEO plays a major role, how do you reconcile this conflict?

When an energy company client is talking to JEF investment bankers, how do they know or not know what information Handler will get to use for LUK's energy business, acquisition opportunities etc.?

At big banks like GS and JPM, the CEO is not involved as key decision makers in deals that the private equity arms do.  They may know what's going on, but they are not the deal makers.  At the new LUK, it seems like Handler will be the key decision maker on deals at the non-JEF LUK, basically replacing Cumming as CEO.

I don't have any doubt about the honesty and integrity of the folks at LUK and JEF so this is not a question about that.  It's just a practical question that comes to my mind.

So What Do I think?
My first impression from looking at all this stuff on first pass is that I like it.  I understand that many probably won't.  There may be some disappointment that the merger is with an investment bank that is prone to the booms and busts we have seen recently, and that is not something to look forward to.

One great thing is that if investment banking is in fact dead and won't ever recover, this deal can still work out because Handler can reallocate capital out of the investment bank into other LUK areas, just like BRK does with their insurance business.  This internal capital fluidity, I think, is a huge advantage.  In that sense, owning the combined LUK/JEF is probably better than owning an independent investment bank.

I like and respect all of the parties involved and see no problem with the people, intent of the deal or anything like that. 

I do own LUK and will be looking to buy more (maybe through JEF) as I do think it's cheap.  JEF is also small and nimble enough to be able to take advantage of the changes going on in the industry (European banks scaling back etc.)