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Shares of the securities and investment banking firm Jefferies (JEF) rose more than 14% on Monday. Leucadia and Jefferies announced that both companies will merge their activities. Shares of Leucadia fell some 3.0% during the session.

The Deal

Leucadia National Corporation (LUK) and Jefferies Group announced before the market open that both companies will combine their activities. Leucadia already owns 28.6% of the shares outstanding in Jefferies Group. Under the terms of the deal, it offers 0.81 shares in Leucadia for every share of Jefferies which it does not currently own.

The exchange is intended to be tax-free for Jefferies' shareholders. Upon completion, 35.3% of Leucadia's common stock will be held by shareholders of Jefferies. The deal values Jefferies at $3.6 billion.

Jefferies will continue to focus on its investment banking businesses on an independent basis, and is well-positioned to continue to grow with Leucadia's support. The strong balance sheet guards Jefferies' franchise against volatile market conditions.

Based on Monday's closing price of $21.14 for Leucadia, this values Jefferies at $17.12 per share. Shares of Jefferies closed at $16.27, trading at a roughly 5.0% discount compared to the implicit offer.

Jefferies' CEO and Chairman Richard B. Handler commented on the deal, "This merger will allow us to operate from a position of even greater strength, take advantage of opportunities that arise in and around the business of Jefferies, and continue Leucadia's longstanding practice of smart value acquisitions and investments. Our substantial combined equity base, ample liquidity and long-term focus will all support meaningful long-term value creation for Leucadia and Jefferies' shareholders."

For the first nine months of 2012, Jefferies generated revenues of $2.23 billion. The company net earned $211 million, or $0.91 per diluted share on a non-GAAP basis.

At this rate, full year revenues could come in around $3 billion with net earnings coming in around $280 million. Based on Leucadia's closing price of $21.80 on Friday, the deal values Jefferies at $17.66, or $3.6 billion. This values the firm at roughly 1.2 times annual revenues and 12-13 times annual earnings.

Richard Handler, the current CEO of Jefferies will become the new CEO of Leucadia. Jefferies will remain an independent firm within Leucadia submitting its own financial reports and retain an independent credit rating.

The merger is expected to close in the first quarter of 2013, and is subject to customary closing conditions, including shareholder approval. Leucadia will spin off the Crimson Wine Group with a book value of $197 million, to be distributed to Leucadia's shareholders prior to the merger.

Valuation

Leucadia ended its third quarter of its fiscal 2012 with $1.16 billion in cash and equivalents. The company operates with $1.36 billion in short and long term debt for a modest net debt position.

For the first nine months of 2012, the company generated revenues of $6.7 billion, on which it net earned $400.3 million, or $1.62 per diluted share. Roughly 90% of total revenues are generated by the beef processing services, with the remainder of activities focused on manufacturing, gaming and investments, including the stake in Jefferies.

After Monday's 3% decline, shares are valued at $5.2 billion. Given a full year revenue outlook of $9 billion and a $500 million earnings target, the firm is valued at 0.6 times annual revenues and 10 times earnings.

Leucadia currently pays an annual dividend of $0.25 per share, for an annual dividend yield of 1.2%.

Investment Thesis

Year to date, shares of Leucadia have fallen some 7%. Shares rose from $23 to a peak of almost $30 in February. Shares fell back to $20 in the beginning of the summer, currently exchanging hands at $21 per share.

The holding company aggressively expanded its business by acquiring a 78.9% stake in the National Beef Company. It furthermore already held a stake in Jefferies. Last year, the company bought a 37% stake in Linkem S.p.A and a 27.3% stake in Mueller.

The merger between the capital strong holding company Leucadia, and investment bank Jefferies comes as quite a surprise. The company already held a stake in Jefferies and the strong capital base of the holding firm drove the companies in each other hands. CEO Handler makes Jefferies' balance sheet more resilient, helping to avoid the negative impact of market turmoil which threatened the business last year.

The deal marks the second merger in the middle-market for investment banking services in a week. Last week, Stifel Financial (SF) acquired KBW (KBW) in their attempt to create a premier middle-market investment bank.

Leucadia's board of directors boosted payouts to shareholders after announcing the deal. The board has authorized the repurchase of 25 million shares, and increased the frequency of its dividend to a quarterly basis, for an annual dividend yield of 4.7%

The deal is a net positive for Jefferies' shareholders. The valuation of the company's assets will increase as investors discount the probabilities of the firm landing in financial markets turmoil again. On the other hand, the holding company now mainly consists out of two very large companies, one in the meat industry and one investment bank.

When investing, I prefer to invest in focused companies instead of diversified holding companies.

Source: Merger Between Jefferies And Leucadia Secures The Investment Bank's Future