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.)

JEF Up 20%

So it's nice to see Jefferies Group (JEF) stock up 20% today to just over $14.00 after dipping below $10.00 at one point in November.

Despite the panic and near-run on JEF due to a faulty report be Egan-Jones, JEF managed to make money in the quarter.  The market is relieved and the stock price is showing it.

I won't get into details on the quarter or yearly earnings announced today, but there was an interesting comment on the conference call:  JEF said that this 'issue' of misinformation and misunderstanding in the quarter really disrupted their business and that if this didn't happen, they might have had yearly earnings of $400 million and revenues of $3 billion or so.

That would have been $1.81/share giving JEF a valuation of less than 8x p/e even at the current price of around $14/share, and an ROE of 11.7% and a return on tangible book value of 13% which is not bad at all in this environment.

Of course, there is no guarantee that that is what JEF would have earned.  I think they just looked at the run rate revenues and earnings up until the panic set in when they had to take measures to shrink the balance sheet and deal with a market where customers fled and counterparties hesitated etc...

Anyway, I don't own JEF but I am still bit shocked at the incompetence and carelessness of Egan-Jones in publishing such a sloppy report and his refusal on live TV to admit the error.  An admission of error would be a blow to the credibility, of  course, to Egan-Jones but his refusal to admit a simple mistake to me is much more enlightening and scarier.

Again, this sort of really explains some of what happened during the upside of the credit bubble, and now these same organizations threaten to cause panics and runs at totally viable institutions.

I am more in favor of restructuring this industry than ever before having been supportive of them over the years (even though I would never depend on their research or opinion of anything).

Cheap and Cheaper

I know, this is a broken record blog.  We all know financials are cheap and we all know there are plenty of reasons why they are cheap and why they might be right to be priced cheap.

However, I tend to still like the well-managed financials.

This is laughable and I don't mean to suggest financials should trade at over 3x tangible book value, but here's a valuation of historic deals in the investment banking sector I pulled out from the Merrill Lynch merger proxy (merger proxies are great sources of information; investment banks do a lot of valuation work to validate deal values and you get all that stuff for free in the filings):

OK, that came out pretty small but historic investment bank acquisitions have happened at an average of around 3x tangible book value with a median valuation of 3.4x.

Of course, this is pre-crisis so the world is quite a bit different now.

But I do think investment banks are certainly worth more than tangible book, if not a multiple of it.  Right now, people are worried about a complete European implosion and financial blowup that may be worse than what we saw in 2008/2009 in the U.S. 

Anyway, here's a list of price-to-tangible book values that was in the "Heard on the Street" page of the Wall Street Journal this morning:

                                   PTBV ratio
J.P. Morgan                95%
Goldman Sachs          76%
Jefferies Group            76%
Citigroup                    52%
Morgan Stanley          51%
Bank of America        44%

As I mentioned before, I really do like J.P. Morgan (JPM) and Goldman Sachs (GS).  I do think they are both very well managed.  JPM is a huge bank so will be subject to macro forces, but management has proven they can handle once in a hundred year events.

GS, too, has managed the crisis pretty well but they may be more flexible and agile than JPM since they are not a major bank.  Investment banks tend to be pretty nimble.  GS doesn't have a large physical presence (bank branches) or a large retail sales force (retail brokers) so don't have a large fixed cost base burden.  If things don't recover, you can be sure they will cut costs quickly and will move capital to where they can earn an adequate return.

At this point, according to the recent earnings conference call, GS is waiting for things to clear up a bit since things are in a sort of 'crisis' situation.  They do think that when things stabilize they will be able to deploy capital profitably.  If they thought this downturn is permanent, they would then use their excess capital to repurchase shares (and will probably cut more costs).

An interesting play here too is Jefferies Group (JEF).  I don't own JEF, but tend to really like it especially so cheap.  They are a small investment bank which has good sides and bad.  Right now, they are seeing the bad side of it.  JEF shares have tumbled alot after the MF Global blowup; people are now concerned about smaller firms that are too small to survive (versus too big to fail firms).

Some of my favorite value managers at Leucadia (LUK) bought into JEF stock on this decline as they are confident in the management of Richard Handler.  I think JEF will be able to pull through this as they do have a great reputation and Handler is known to be a conservative CEO (unlike the more risk-taking, reckless Corzine).

But in finance, you never know.  Good firms will go down in crisis situations, sometimes (although I don't think that happened in the 2008/2009 crisis; I think the firms that went down in that crisis weren't really good, well managed, conservative firms.  They were reckless, aggressive, overleveraged, horribly managed firms (BSC, LEH etc...)).

The good side of a smaller investment bank like JEF is that they may have more opportunities if they have a good niche (many smaller investment banks like Cowen haven't made money in years) and are well-managed.  The good thing is that they don't depend on mega-deals.  Bigger investment banks have to do bigger and bigger deals to increase revenues, just like larger and growing private equity funds have to do bigger and bigger deals to deploy bigger and bigger amounts of capital.

Anyway, all of these are financial companies and as I keep saying, one should be very careful how much exposure they have in any single sector (otherwise, I would be buying JEF too, but I have enough financial exposure now).

If Europe does really implode, financials can certainly go down more.  By their very nature, they are risky and another financial crisis of bigger than 2008 proportions is not a zero probability.

I do talk a lot about financials here now just because I do tend to think they are cheap, and because of my experience in the industry I tend to be more comfortable with some of them than most other investors and the general public (that seem to resent/hate financials!).

But that doesn't mean investors should pile into these things too much!

Stunningly Bad Analysis

I can't believe how sloppy and bad some of these credit rating agencies are, and it's really obvious how dangerous they are.  We saw how sloppy and bad they were when things melted down in 2008/2009, but this came as a surprise because the perp is Egan-Jones, a small rating agency that wants to compete with the majors, Moody's, S&P and Fitch by being better and more independent (not paid by issuers etc...).

The latest fiasco with Jefferies Group (JEF) is insane.  Egan-Jones downgraded Jefferies after the MF Global bankruptcy because JEF owned $2.6 billion or so of problem sovereign bonds in Europe.  First of all, this seems highly reactionary to me; to downgrade something right after an event like the MF Global bankruptcy.   It's as if they didn't realize that there was a sovereign debt problem in Europe until the MF Global bankruptcy, or didn't notice this $2.6 billion position until then.

And then to only mention a long position in a market-making, hedged book of bonds seems highly ignorant of how investment banks work.  Incredibly sloppy thinking.

Thankfully, JEF responded quickly and clarified their positions.  However, Egan-Jones refused to back down and made a silly statement.

Here's a cut and paste from a Wall Street Journal article:

JEF did clarify that their short positions were in securities and weren't default swaps or other derivatives with credit risk.

This is no different than a long/short inventory position of equity market-makers.  Market-makers have billions in stock inventory but is mostly hedged and this has not been a problem, historically.

JEF responded with a series of releases.  Here's one of them:

The position looks fine.  It's incredible that an analyst would only use a long position to evaluate a balance sheet without looking at what's on the other side of it.

Sure, Morgan Stanley blew $10 billion on poorly hedged mortgages during the crisis (or some such incredibly high number), but they were in fact highly complex products with risk characterstics that are very different than sovereign bonds, no matter the credit rating of the bonds (JEF does in fact specialize in high yield).

JEF also owns $1.68 billion in equity securities (with $1.57 billion in equity short positions) and $4.2 billion in corporate bonds (with $3.6 billion shorts); a large part of the corporate bonds are probably high yield, too. 

Why not mention only the long side of those positions too, which may look even more risky?

Leucadia National (read about here), the largest owner of JEF jumped in and bought 1 million shares for $11.84 and 500,000 shares at $11.35.

It is really scary that this sort of bad analysis can possibly cause a run on a perfectly healthy, fine company (I don't own any JEF, but have positive view about them.  Even the very vocal bank critic Meredith Whitney said JEF is run by a very good, conservative CEO).

Anyway, these are scary times to be sure for everyone.  People are very trigger happy; shoot first and ask questions later.  Or in many cases, just shoot, shoot, shoot and don't think or ask questions!