The following article was written in conjunction with the Finance Pupil.
Leucadia (NYSE:LUK) is an American holding company started by Ian Cumming and Joseph Steinberg. The firm has been in the news recently for two reasons. First, the company underwent a transformative merger with Jefferies (JEF), detailed in the following company presentation. Second, the founders announced that they are handing off the reins to Rich Handler and Brian Friedman, who have been CEO and president, respectively, at Jefferies. While there could be some worry that the management change could prevent continued success, Leucadia is positioned to succeed for years to come. While Leucadia is not grossly undervalued it currently prevents a positively skewed investment profile, coupled with elements to ensure strong returns for the long-term investor.
Leucadia provides a visual for the new company in its merger presentation:
Leucadia no longer owns any shares of Inmet. Leucadia received about $341MM worth of shares and $391 worth of cash from First Quantum, in an exchange between the end of fiscal 2012 and the end of the first quarter of 2013. These amounts are now classified in the adjusted cash and public securities cell listed above.
Additionally, this description will likely change as Leucadia is active in acquiring and selling companies. Unlike Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), which generally holds assets in perpetuity, Leucadia has generally in the past regularly sold assets to realize value. While the founders did hand pick the successors, it is to be seen whether the trimming of assets continues. Trimming is likely neither a negative nor positive; however, Leucadia has a very strong track record of buying cyclical and distressed businesses acquisitions.
In general, many of Leucadia's holdings are either service or commodity based, likely due to the founders' bearishness towards the dollar and their belief that these areas can survive weakening of the dollar. While these industries can sometimes have poor economics, the dynamics of the individual holdings are only known by the company. And even if the dynamics are poor, Leucadia could have acquired it at a great (or poor) price. Furthermore, Leucadia is not taking large equity stakes in public companies as Berkshire Hathaway has with companies such as Coca-Cola (NYSE:KO) or American Express (NYSE:AXP). This strategy may have been pursued to utilize the holding company's deferred tax assets or to exert more control over company operations. Finally, Leucadia will remain a diverse holding company, as no investment, other than Jefferies will have a book value greater than 20% of LUK BV, and the next largest investment will be less than 10% of LUK BV, at the time of investment.
Leucadia's structure lends itself to a sum of the parts valuation.
Jefferies is the newest and also the largest part of Leucadia. Jefferies also may be the most difficult to value because it is a financial institution. However, Jefferies should be poised to provide significant value to Leucadia. Jefferies has done well over the years as illustrated by its ability to grow revenue and net income consistently over the past 20 years:
This performance rewarded shareholders with 16% returns per year since 1990 and 9.2% per since 2000, significantly higher than other leading financial institutions. Past returns and performance are not indicative of future performance. At the same time it is difficult to predict growth for a financial company. The company will grow through its ability to grow its balance sheet by plowing money back into the business while avoiding events that may wipe out major chunks of assets. While external factors such as interest rates can influence returns, the largest determinant is adroit management. Jefferies management appears to be strong, having led this growth, and is properly incentivized.
First and foremost, Rich Handler and Brian Friedman have proven their success by leading Jefferies through the financial crisis; in fact the company was able to triple revenue from 2008 to 2011 while reducing the cost of capital by buying and selling its debt at opportune times created by volatile markets. The adroitness of management has continued as they managed the MF Global crisis that threatened Jefferies. Management has not forgotten the financial crisis and is keeping leverage (gross assets/equity) levels significantly lower (currently at 10X) than they have been in the past.
Click to enlarge images.
Sources: Leucadia Investor Presentation and Google Finance.
Jefferies should likely trade at a slight premium to TBV because of its historical ability to grow faster, its smaller size relative to competitors which allows Jefferies to grow faster, and its lower leverage which should make the holding less risky. Furthermore, Jefferies will retain more cash than it did as an independent company; profits Jefferies no longer has to pay dividends ($62MM) or distributions related to Jefferies High Yield Holdings (JHYH) ($84MM). The extra capital should allow the new Jefferies to grow more quickly. This equates to about 9.3% return on tangible equity.
While the deferred tax asset of Leucadia of approximately $1.8B will be accounted for separately, it is worth noting that Leucadia will principally monetize this asset through Jefferies because it will have the most consistent cash flows. Given these features a reasonable valuation for Jefferies can be found through the following multiples on tangible book value of Jefferies, as TBV provides the base from which Jefferies can grow. The motivation for the multiples comes from the following charts and data:
Sources: Google Finance, Ycharts.
While Jefferies has generated a lower ROE than some banks, it has consistently grown faster; price to tangible book for a bank is essentially directly proportional with ROE and the growth rate, and inversely proportional with the rate of return demanded. Given that rate of return for banks should be similar, the extra growth of Jefferies should counterbalance its ROE, and should trade inline based upon TBV with comparables. This leads to the following:
Liquid Leucadia and Deferred Tax Asset
Leucadia currently has about $1.8B in deferred tax asset. It is difficult to determine if the time value of the actual NOLs is factored into the deferred tax asset. To conservatively account for this, the stated asset can be discounted at 8% per year over five and 10 years for the base and bear cases:
Leucadia currently has $123MM cash and equivalents and $2.794B in available for sale securities (AFS). These assets can be summarized by the following:
Of the fixed income about 64% has duration under a year implying high liquidity and low risk to interest rate changes. Much of Leucadia's equity holdings are publicly traded, and LUK should be able to easily liquidate these assets. Consequently, the value of these assets will likely be stable. This liquidity should give Leucadia the ability to respond well to changing market conditions. To be conservative, the AFS can be reduced by 30% in the bear case.
Investments Associated Companies
Leucadia ex-Jefferies currently has investments in the following companies accounted by book value:
There is reason to believe that some of these holdings are worth significantly more than book value. Berkadia is 50-50 JV with Berkshire Hathaway, and originates and services commercial loans. Leucadia originally invested about $217MM into the JV. And yet the holding is now listed below that despite significant recent profits ($38MM EBT in 2012) due to the strong refinancing environment. It seems highly unlikely that two of the best capital allocating organizations would have an investment that lost equity over a medium time horizon. Comparable WD currently trades at about 8.9% EBIT/Market Cap. Even after applying WD's EBT/market cap yield to Berkadia's three-year average, Berkadia's value is still noticeably higher.
Garcadia is a JV with Garff; Leucadia generally receives about two-thirds of the cash flows from the JV. Comparable company CarMax (NYSE:KMX) is a good comparable as both own the car dealerships and sell cars. KMX currently trades at about 6.9% EBIT/market cap. It also has significant debt making its EBIT yield higher than it would be with no debt. Applying even a higher EBT yield and averaged earnings still yields a higher value for Garcadia. HomeFed's (OTCQB:HOFD) valuation is straightforward. HomeFed trades OTC and currently trades at about 1.5X book, while Leucadia carries it at just book.
The other assets have some combination of lack of comparables, poor earnings, or little information. To be conservative, the value of these can be taken at book. Because of the size of these holdings, one is not missing significant value.
Outside of Jefferies, National Beef is Leucadia's next largest holding. LUK's 79% stake has a stated book value of $860MM. Once again, book value likely undervalues National Beef. At first glance Tyson Foods (NYSE:TSN) and Smithfield Foods (NYSE:SFD) may be poor comparables because they are not exposed to the beef industry. However, the dynamics of the industries are the same and all industries are in or close to the trough of the cycle. Net income for Tyson and Smithfield is over 25% and 60% below peak earnings from the past three years. Similarly, the beef industry experienced a poor year in 2012; according to LUK's most recent 10-K, "the ratio (USDA comprehensive boxed beef cutout to five area weekly slaughter cattle price indicative of profitability) during 2012 was the lowest ratio for the corresponding periods during the past 10 years."
So while a comparison is imperfect, it is possible. Additionally, National Beef is taking massive amortization (D&A = $83MM for 2012) charges as Leucadia ascribed significant value to intangible assets for National Beef. On a cash flow from operations basis (assuming 35% tax rate), it earned at least $100MM. If we calculate net income plus D&A for Smithfield and Tyson, National Beef trades well below these companies.
Idaho Timber is a fully owned business that produces and re-manufactures dimensioned lumber. Business has been tough recently due to the decline in the housing market. However, if the industry rebounds, Idaho Timber could grow book value very quickly, and current industry conditions create a positive skew. Idaho Timber is likely worth significantly more than 10X EBT as indicated by current book value. Casinos are likely worth more than book. These casinos have many hard assets and intangible assets such as brand name that have likely appreciated in value beyond costs since the 2007 acquisition.
Conwed Plastics is currently trading at about 6X EBT according to book. While there is no direct comparable to truly justify a higher multiple, it is highly unlikely that the owners value Conwed at just 6X EBT. A multiple of 12X in a sale is likely reasonable.
Leucadia owns about $245MM worth of real estate assets not including the Mississippi gambling operations. The base case can conservatively take the value of the real estate assets at this value, and the bear and bull slightly below and above this value. Leucadia has a $22MM investment in Sangart, a development stage pharmaceutical company. The company is currently leaking money and Leucadia is unsure as to whether the company will ever make money because further testing is needed. However, if the product does work, profits could be significant as Leucadia has already invested $261MM into the firm. However, for this valuation, Sangart will be valued at just book for the base and bull and zero for the bear.
A summary table of all these holdings is as follows:
Debt and Other Considerations
The current balance sheet of LUK lists about $19.5B of total debt and about $7.8B of long-term debt for Leucadia. However, much of that is due to Jefferies and is already accounted for in Jefferies TBV. Some of the debt is also from subsidiaries, is not recourse to the holding company and already accounted for in those holdings' book values. The holding co. debt is:
Furthermore, LUK currently has $125MM worth of preferred shares as liabilities.
The summary of these values leads to the following table:
Leucadia is likely somewhere between fairly and somewhat undervalued. Currently one can buy Leucadia at about 1.36X TBV, as much of LUK's goodwill comes from Jefferies, which was valued according to TBV. Furthermore, the intangible assets of LUK, largely from National Beef, are already being expensed. Since the company's significant rerating in the late 1990s, LUK has on average traded at 1.43X BV. LUK currently trades at 0.94X BV. While the complete addition of Jefferies does make for a different comparison, Leucadia ex-Jefferies is trading below historical multiples unless Jefferies is ascribed a TBV multiple at or below one.
Leucadia's stock price has grown in step with its book value; so unless Leucadia switches to fair value accounting for some of its holdings, highly unlikely, investors will not realize the true value of LUK's holdings over the short term. There simply is not enough information disclosed by Leucadia for the market to make these judgments. Over the long term, however, the true value of these assets will be gradually realized. Furthermore, owning undervalued assets provides a nice floor to the company's value. This floor is strengthened by Leucadia's valuation, creating an asymmetric positively skewed profile.
While Leucadia's undervalued holdings may create some returns for investors, they still have to grow book value over the long term to generate significant returns. Successful management, will be by far the largest determinant, as executives will be responsible for properly deploying capital through capital expenditures in existing subsidiaries, pursuing new ventures, selling current holdings, or buying new holdings.
While it may be impossible to replace Steinberg and Cumming, Handler and Freedman do not appear to be bad choices. They have already proven themselves during their time at Jefferies. Additionally, these individuals were handpicked by Steinberg and Cumming after looking for years for successors. Being the ultimate choice of these extremely successful business men should be worth something.
Management and shareholders' interest are also aligned. Handler and Friedman own about 11.2MM and 5.3MM shares, respectively, totaling nearly 4% of the company. These two will likely become further invested in the company as it issues options typically every other year to encourage strong future performance. In particular, Leucadia issues out of the money options to deter stagnation. LUK believes there should be a "strong link between pay and performance" and consequently ties a large portion of pay to bonus incentives. Finally, it appears that Leucadia rewards executives appropriately by focusing on cash flows and return on investment.
Even if they cannot duplicate the 18%-plus growth rate of book value produced by the founders, the above -- combined with the state of Leucadia's assets -- should allow Leucadia to still earn above average returns for years to come.
Disclaimer: This article presents the author's opinions and findings. The author encourages others to do their own due diligence.