Jefferies Group Inc. (JEF) capped off its 2012 fiscal year today and I don't believe it would be a stretch to say that this is probably the most significant year in the company's history. Jefferies management, led by CEO Richard Handler, has continued to invest aggressively on acquiring key talent and expanding the company's global reach throughout the last several years. This has led to increased market share in key businesses but it has also translated into increased costs associated with bonuses, as often when a key individual is hired the up-front costs are significant, and there is amortization over the following couple of years. While the business had made progress despite an extremely lackluster global economic environment, the world turned upside down to some extent for Jefferies this November, when its largest shareholder Leucadia (LUK) announced its intention to acquire Jefferies. The impact of this acquisition is difficult to calculate because Richard Handler will be the acting CEO of Leucadia, which has historically been a conglomerate and it is unclear whether or not the combined company will delve deeper into financial services, or will continue to maintain a very diverse asset base.
When we started writing about Jefferies the stock was much lower than it is now. We had liked the business for some time, but we gained a new appreciation for the company when we saw how management handled a serious bear raid spurred by Sean Egan's erroneous research report in late 2011. That spurred us into buying the bonds at a discount, selling puts and acquiring stock. Jefferies is unique in the financial industry in that it is an extremely transparent company. It is not a bank-holding company and there are pros and cons to that, but I'd probably take Richard Handler over any of the big bank or investment bank CEOs, and Jamie Dimon of JPMorgan (JPM) would be right up there as well. When things were at their worst, Handler was at his best buying back his own stock, purchasing JEF debt at a discount, and articulating exactly where the company stood in its trading positions to quell the incorrect rumors.
Since that time the business has executed nicely despite a really weak trading environment for most investment banks, aside from brief flurries in fixed income and capital markets. Whenever markets have stabilized the party has ended quickly with a new crisis in Europe, or gridlock in Washington D.C., which hurts confidence and risk taking amongst Jefferies customers. Ian Cumming and Joe Steinberg of Leucadia have been Jefferies shareholders for several years, in addition to having a fixed income joint venture with the company. It appears that working closely with the company and with Handler in particular that they saw an organization and individual that they felt comfortable succeeding them as they look to retire over the next year or two. This is an extremely large compliment when you consider Leucadia's fabulous track record of making calculated investments to create value for Leucadia shareholders.
The acquisition should provide value for both Jefferies and Leucadia shareholders as we discussed in more detail at the time of the merger. Jefferies' stock has continued to rally in the winter and now trades at a premium to book value, which is truly an outlier for the beleaguered investment bank industry. If it weren't for the Leucadia acquisition I would possibly recommend exiting Jefferies and then investing in either a Morgan Stanley (MS) or Citigroup (C) to take advantage of the valuation gap between the companies. We are more heavily invested in the larger banks than we are in Jefferies, but I'm intrigued about what could happen when Jefferies' improving earnings power is combined with Leucadia's investment acumen. I believe that Jefferies will benefit from a stronger credit profile and much of the long-term shareholder returns will be based on how well the combined company allocates surplus capital. While many financial stocks are likely to be dramatically increasing dividends, I'll be curious to see if the combined company retains the earnings to allocate them based on the highest risk adjusted return investment opportunities, regardless of industry. I don't know the answers to these questions but I suspect we'll learn more as the merger gets closer, but knowing the secrecy of Leucadia, I doubt we'll learn as much as we'd like to so a lot of it comes to faith in management.
On December 18th, Jefferies reported 4th quarter earnings that were extremely strong. Net revenues of $769MM were up dramatically versus $554MM the prior year. Net income to common shareholders' was $72MM while earnings per share were $0.31. Net income would have actually been $81MM and EPS would have been $0.35 on a non-GAAP basis without the negative impact in the quarter from fees and expenses attributable to the proposed merger with Leucadia, and the company's $4.1MM contribution to the Hurricane Sandy recovery effort and certain other non-recurring items. For the full year revenues were just a hair under $3 billion, and were up from $2.548 billion in fiscal year 2011. Net income to common shareholders' for the year was $282MM and earnings per share were $1.22. Annual net income would have been $302MM and EPS would have been $1.31 without the previously mentioned items. During the 4th quarter, Jefferies acquired 603,000 shares at an average price of $15.53, and the company still has 11.5MM shares authorized for future repurchases. Book value per share was $16.90 at quarter-end based on 203MM shares outstanding. Adjusted book value per share was $16.01 based on 215MM shares outstanding, including vest restricted stock units but excluding unvested restricted stock.
Ever since the scare late in 2011, Jefferies has dialed down its leverage and boosted liquidity. A 9.6 times leverage ratio is below historical averages and leaves room for the company to ratchet it up if a really attractive opportunity were to come around. Jefferies believes it has over $4 billion in excess liquidity encompassing cash unencumbered securities. Level 3 assets represent only about 3% of the company's trading inventory, which is very low in relation to peers. The company still has a lot of work to do on the compensation side of the equation and right now that is my biggest concern with Jefferies. The 2012 compensation expense ratio was 59.9% for the 4th quarter and 59.1% for the full year. This is high by any standards and is something that I have a tough time justifying. I understand that a lot of these costs are front-loaded but in Wall Street loyalty can be fickle, so I don't view these types of long-term investments to be as secure as IT infrastructure improvements or a new more efficient manufacturing plant might be for other industries. If these new teams of talented personnel were to leave at the first smell of more dollars, these large compensation costs might have been better off being redirected to shareholders in a greater amount.
The Knight Capital Group (KCG) rescue was another innovative move by Jefferies and Handler. The company came up with the idea of the convertible preferred securities, which allowed Jefferies to take a large position in Knight at $1.50 per share. Jefferies acquired $125MM of the $400MM in securities, giving Jefferies close to 23% ownership of the company, and now is close to realizing a huge profit as Knight Capital Group weighs several different buyout options well in excess of $3 per share. Jefferies and Leucadia are definitely stories that should be fun to watch over the long-term, as I believe the combined entities could compound book value at a greater level together than on their own. I wouldn't necessarily recommend buying the stock at current prices because there are some stocks I believe to offer more attractive values, but I'm not in a rush to sell the stock that we do own either. Previously we sold a lot of put options as an arbitrage on the merger and those have already become quite profitable and warrant an exit at any time now.