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Executives

Richard B. Handler - Executive Chairman, Chief Executive Officer, President, Member of Risk Management Committee and Director of Jefferies

Peregrine C. de M. Broadbent - Chief Financial Officer, Principal Accounting Officer, Executive Vice President and Member of Risk Management Committee

Brian Paul Friedman - Director, Chairman of Executive Committee, Member of Risk Management Committee and President of Jefferies Capital Partners

Analysts

Joel Jeffrey - Keefe, Bruyette, & Woods, Inc., Research Division

Christoph M. Kotowski - Oppenheimer & Co. Inc., Research Division

Patrick J. O'Shaughnessy - Raymond James & Associates, Inc., Research Division

Michael Rogers

Jeffrey Harte - Sandler O'Neill + Partners, L.P., Research Division

Jefferies Group (JEF) Q2 2012 Earnings Call June 19, 2012 9:00 AM ET

Operator

Welcome to the Jefferies 2012 Second Quarter Financial Results Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. A press release containing Jefferies' 2012 fiscal second quarter financial results was distributed via Business Wire earlier this morning and can be accessed at jefferies.com.

Some of the comments made in this conference call may include forward-looking statements. These forward-looking statements may contain statements about management's current assumptions, expectations, strategic objectives, growth opportunities, business and prospects. These forward-looking statements are not statements of historical fact and represent only Jefferies' belief as to future performance. They usually include the words continue, will, believe, should, estimate or other similar expressions. Actual results could differ materially from those projected in these forward-looking statements. Please refer to Jefferies' Annual Report on Form 10-K filed with the Securities and Exchange Commission on January 27, 2012, and Jefferies' Form 8-Ks for discussions of important factors that could cause actual results to differ materially from those projected in these forward-looking statements.

I would now like to introduce your host for today's conference, Mr. Richard Handler, Chairman and CEO of Jefferies. Mr. Handler, you may begin your conference.

Richard B. Handler

Good morning, and thank you for joining our discussion of Jefferies' second quarter results. I am Rich Handler, CEO of Jefferies, and with me on the call today are Brian Friedman, Chairman of our Executive Committee; and Peg Broadbent, our Chief Financial Officer.

For the second quarter ended May 31, 2012, we posted net revenues of $711 million, net income to common shareholders of $63 million and earnings per share of $0.28. Net income would have been $72 million and EPS would have been $0.31 on a non-GAAP basis without the negative impact of the current quarter of certain items arising from acquisitions and debt extinguishment accounting gains recognized in prior quarters and a modest impairment charge taken this quarter, which Peg will discuss later.

Our results reflect our continued momentum in Investment Banking, where we posted revenues of $297 million and the durability of our sales and trading platform despite the challenging market environment that persisted during the quarter. Secondary trading activity was muted as investors' concerns were exacerbated by the state of the global economy and Eurozone sovereign and bank credit risks. The optimism about a solution to the Eurozone debt issues, which prevailed during the first quarter, deteriorated during the second quarter. Uncertainty about the future of the euro translated into lighter global fixed income activity as the quarter progressed.

Equity volumes remained muted throughout the quarter much as they have been for the past year. At quarter end, our assets were about $35.7 billion or roughly and 9.8x shareholders' equity, and our liquidity remains solid. To the extent we continue to experience market volatility as a result of global economic and financial uncertainty, we will maintain reduced levels of risk and leverage while still providing appropriate liquidity to meet our clients' trading needs.

Since 2007, the global financial markets generally have been unstable and under significant duress despite brief periods of robust activity. Governments and regulators have been challenged to make the needed decisions and changes, while the liquidity models and even basic business models of many financial services companies have been called into question. Our goals during this prolonged period of stress have been to deliver solid results, manage risk effectively, increase our market share with our clients around the world, further diversify our capabilities and presence, protect our firm and persevere our way to an even better competitive position. While it has not been a particularly enjoyable period, we are proud of our 3,809 employee-partners whose hard work has made Jefferies a much broader and stronger firm with better results, better market share and long-term competitive position than before all this began. We are committed to continuing this hard work regardless of how long it takes for the global financial market to stabilize.

Now I will turn over to Peg to discuss our results and financial condition in more detail.

Peregrine C. de M. Broadbent

Thank you, Rich. As Rich said, our net revenues for the second fiscal quarter was $711 million. Our net income to common shareholders was $63 million, and earnings per share $0.28, versus $0.36 for the second quarter last year. Also, as Rich mentioned, net income would have been $72 million and EPS would have been $0.31 on a non-GAAP basis without the impact of amortizing certain items arising from acquisitions and debt extinguishment accounting over the last 3 quarters and the effect of a modest impairment charge recognized this quarter. We'll briefly discuss these items before going through the operating results.

During the last 3 quarters, we recorded bargain purchase gains relating to the Bache and the Hoare Govett acquisitions, as well as the debt extinguishment gain arising purchase of our own debt. Last quarter, we also mentioned that these items were to result in amortization expense in the future quarters with an expected negative impact to pretax earnings of about $5 million for each of the second, third and fourth quarters of this year. The actual total impact of these costs to the second quarter was to reduce pretax profits by $11 million. This $11 million includes acceleration of about $6 million of Bache pretax compensation expenses for employees that are no longer with the firm.

In addition to this $11 million, this quarter, we wrote down the carrying value of some Bache trading exchange seats, which increased our pretax operating expenses by about $3 million. These seats were brought onto our balance sheet at fair value last summer as part of our Bache acquisition. The aggregate impact to our profits of the amortization costs, accelerated compensation and the impairment write-down was a reduction of about $14 million on a pretax basis or a reduction in net earnings of $8 million or approximately $0.035 per share. These details are set out on Page 9 of our press release.

Now for the operating results. Our second quarter Investment Banking revenues were $297 million, up slightly from this year's first quarter but lower than our record Investment Banking revenue of $328 million reported in the second quarter of 2011. Of the $297 million, Capital Markets revenues were $188 million and M&A and advisory revenues were $109 million.

Fixed Income revenues were $293 million for the second quarter, up 31% from last year's second quarter of $223 million and down from the strong first quarter of $339 million. Equities net revenues for the second quarter were $120 million, lower than both the $165 million reported in the comparable quarter last year, and the first quarter's $136 million. Asset Management revenues for the quarter were about $2 million versus the $6 million reported for the first quarter and the $10.5 million reported for the year-ago quarter. About $8 million of fee income this quarter was offset by $6 million of unrealized markdowns in our investments in unconsolidated funds.

Non-compensation expenses were $176 million versus the seasonally lower first quarter of $163 million. Last year's second quarter non-compensation expenses of $160 million were prior to our Bache acquisition. Our compensation expense ratio for the second quarter was 59.6% of net revenues, consistent with recent levels.

During the quarter, we repurchased 2.2 million shares at an average price of $15.77 per share. There are still about 12.6 million shares authorized for future repurchases. Book value per share was $16.23 at quarter end based on 204 million shares outstanding. Our adjusted book value per common share was $15.35 based on 226 million shares outstanding, including restricted stock units.

As Rich mentioned, we estimate total assets at May 31 were about $35.7 billion or about 9.8x our estimated shareholders' equity. We estimate our total quarter-end Level 3 trading inventory, after accounting for noneconomic interests, was approximately $446 million. The vast majority of our trading inventory continues to be highly liquid with 97% of our inventory continuing to be classified as either Level 1 or Level 2, which is consistent with levels of previous quarters.

We estimate our quarter-end liquidity buffer was about $3.4 billion. Of the $3.4 billion, we estimate $2.4 billion was cash and $1 billion was unencumbered liquid securities. We estimate our average VaR for the quarter was approximately $8.8 million compared to last year's $9.9 million and the $13 million reported in the second quarter of 2011. Our estimated tax rate for the quarter was 35.8% versus 35.1% in the second quarter of 2011.

On May 31, we had a total of 3,809 employees, a net decrease of 42 from the 3,851 at the end of the first quarter, primarily reflecting our ongoing efforts to streamline and create efficiencies within our support functions. We are committed to optimizing our infrastructure over the coming periods through efficiency and operating leverage.

Brian will now address in more detail our Investment Banking results.

Brian Paul Friedman

As Peg indicated, Investment Banking revenues were a very solid $297 million for the second quarter, an increase of 4% from the $286 million generated during the first quarter. Our M&A and advising revenues were $109 million in the second quarter. During the quarter, we announced or closed 46 M&A and restructuring transactions.

Notable deals included acting as joint advisor to Cordillera Energy Partners in its $2.85 billion sale to Apache Corporation. We also jointly advised First Quantum Minerals in its $1.25 billion sale of mining assets in the Democratic Republic of Congo to ENRC. We advised DS Waters on its $900 million restructuring of the company's credit facilities and advised Reddy Ice Holdings in its $535 million restructuring. We also sole advised Semtech Corporation on its $494 million acquisition of Gennum Corporation, and were sole arranger on the $350 million credit facility used to finance this acquisition. We jointly advised Williams Partners L.P. on its $2.5 billion acquisition of Caiman Eastern Midstream LLC. We also sole advised Physiotherapy Associates on its $510 million sale to Court Square Capital Partners, and we were joint arranger on the $125 million credit facility and joint book runner on the $210 million in senior notes used to finance this acquisition.

Our M&A backlog remained solid, driven by our leading sell side franchise and supported by the continued need of strategic buyers to acquire growth and of financial sponsors to monetize their portfolios in the face of a challenged IPO market.

Our capital markets revenues were a strong $188 million with debt capital markets generating $132 million and equity capital markets $56 million. During the quarter, we completed 183 Capital Markets transactions. Notable deals during the quarter included our acting as joint lead arranger on a number of credit facilities, including the $4 billion credit facility for Chesapeake Energy Corporation and $885 million to finance the acquisition by CVC Partners of AlixPartners. We also acted as left lead arranger and book runner for the $1.6 billion refinancing of Landry's. We were also joint book runner on several senior notes offerings, including $856 million for Carlson Wagonlit, $775 million for Vantage Drilling and $400 million for Check 'N Go.

In equity capital markets, we acted as joint book runner on several IPOs, including the $165 million IPO of Edgen Group, the $160 million IPO of Western Asset Mortgage Capital, the $145 million IPO of XPO Logistics, the $131 million IPO of M/A-COM Technology Solutions and the $123 million IPO of Yelp Inc.

Regarding follow-on offerings, we were joint book runner on the $599 million MLP offering of Williams Partners, the $399 million common stock offering of Alkermes plc and the $248 million common stock offering for Francesca's Holdings.

Finally, we were sole manager on a $610 million Ginnie Mae commercial mortgage securitization, our largest ever; joint book runner on our first non-agency commercial mortgage securitization of $1.6 billion, the largest portion of which was originated by our Jefferies loan core joint venture; and sole manager on a $600 million CLO for ICE Canyon. We also acted as senior manager for a $1.8 billion State of Illinois general obligation bond.

As this long and varied list of transactions indicates, our breadth and depth of activity in Investment Banking is outstanding, and we have solid momentum.

Now Rich will comment on our trading results before we take questions.

Richard B. Handler

Thanks, Brian. Our Fixed Income revenues were $293 million for the quarter, up 31% as compared to $223 million a year ago and down from the first quarter's very strong $339 million. Despite the more challenging environment, our mortgage, rates, credit and munis businesses performed well during the period. Our Equity revenues were $120 million for the quarter, down from the $136 million reported for the first quarter and the $165 million for the second quarter of 2011. Our core Equity business continues to experience relatively low volumes.

With a reasonably sized balance sheet, we continue to provide focused attention, liquidity, content and capital markets offerings to support our clients' objectives. We expect to continue to enhance our global capabilities to serve our clients across the Fixed Income, Equities, Commodities, Futures Exchanges, Futures -- Foreign Exchange and Futures Markets.

We believe Jefferies is unique today in our intense focus on offering an integrated global capital markets platform to our clients and an entrepreneurial culture to our employee partners. Our goal is to continue to balance our desire to aggressively build our client-focused business lines while delivering solid results and operating with conservative leverage and ample liquidity.

We are now available for questions.

Question-and-Answer Session

Operator

[Operator Instructions] You have a question from the line of Joel Jeffrey with KBW.

Joel Jeffrey - Keefe, Bruyette, & Woods, Inc., Research Division

Can you just -- can you talk a little bit about how you think about managing the size of the balance sheet, first, for the end of the quarter versus sort of the average size of the balance sheet in the middle of the quarter?

Richard B. Handler

We basically have told people, given the environment that we see in terms of the challenging nature of Europe and the challenging domestic economy, that we're going to have a relatively smaller balance sheet for the foreseeable future, which we've done now for the last 3 quarters. Intra-quarter, it rises based upon needs of our clients, but by virtue of the fact that we're 97% Level 1 and Level 2, we have a lot of flexibility throughout the period of time, and it's not very difficult for us to prove the liquidity and the liquid nature of our balance sheet by basically bringing it relatively tight at quarter end, and that's what we've been doing.

Joel Jeffrey - Keefe, Bruyette, & Woods, Inc., Research Division

Okay, great. And the principal transactions line was down quarter-on-quarter, but it looks like it was up year-on-year. Can you just talk a little bit about what was in that and what drove the growth year-on-year?

Peregrine C. de M. Broadbent

Well, the growth year-on-year was driven by strong Fixed Income results, particularly in the first quarter. Most of our Fixed Income activities, albeit on a quasi-agency basis, get captured -- the P&L will be captured through the principal transactions line. As you can see from the revenues by source statement, Joel, however, our Fixed Income results were a little lower in the second quarter, and therefore, the principal transactions line came down a little bit compared to the first quarter.

Joel Jeffrey - Keefe, Bruyette, & Woods, Inc., Research Division

Okay, great. And then can you just give us an estimate, I don't know if you have the numbers in front of you, but just an estimate of what maybe the gross and net exposures to European sovereign debt currently stand at?

Brian Paul Friedman

Very similar levels. They were published in our first quarter 10-Q. Negligible on a net basis, a few hundred million either side on a gross basis, insignificant overall and very similar levels to, as I indicated, to what you would have seen at the end of our first quarter.

Operator

[Operator Instructions] Your next question comes from the line of Chris Kotowski with Oppenheimer & Co.

Christoph M. Kotowski - Oppenheimer & Co. Inc., Research Division

You've one of the few firms that really have used the downturn here for the last 5 years to grow the business by both acquisition and by hiring. And I guess given the protracted nature of the downturn in Europe but then the fact that there just doesn't seem any end in sight, are there opportunities? Is there desire to grow the European business? Are there businesses in geographies that you're not in that you'd like to be in a significant way? And can one -- how big would you be willing to be in Europe relative to the size of the company, I guess, is my question.

Richard B. Handler

I think the answer there is that across the board, both product-wise and geographically, we think we now have a substantial portion of the long-term architecture of our firm. The near to intermediate-term opportunity is to grow it deeper, both in terms of more services for existing clients and more clients in existing capabilities and in existing geographies. So I would say that our emphasis is in going deeper, growing our market share, getting the benefit of the maturation of the people that have come onto our platform over the last couple of years. And clearly, from our point of view, there's no limit to how much growth we would like to generate internally from that capability. If you asked us today where we see the opportunity, it is probably more heavily short-term in the U.S. in terms of the market that has the most positive dynamic and where we're probably getting the best results. At the same time, in Europe, we're seeing the capital markets start to take share from the banks in terms of debt financing, and that's definitely something that is giving us some momentum in Investment Banking and Fixed Income in Europe. In Asia, we're relatively new, and off of a small base, we see long-term opportunity. But I would emphasize that our focus right now is not in geographic expansion but rather in deepening our results within the products and the capabilities we have. We think that the operating leverage and the smart risk reward trade-off here is to leverage within. You would have seen in the last couple of weeks some suggestions that we're expanding in our commodities focus in the metals area. That's definitely something that we see as an opportunity, and we see that as a global opportunity, U.S., Europe and Asia, for expansion.

Operator

Your next question comes from the line of Patrick O'Shaughnessy with Raymond James.

Patrick J. O'Shaughnessy - Raymond James & Associates, Inc., Research Division

Can you kind of provide updated guidance on what you expect your compensation ratio to be for the remainder of the year? I guess that probably depends on your outlook for revenues, but where do you see it coming in for the next couple of quarters?

Peregrine C. de M. Broadbent

At similar levels as for this quarter, so around the 60% kind of mark.

Patrick J. O'Shaughnessy - Raymond James & Associates, Inc., Research Division

Okay, that's helpful. Your interest income came down a little bit quarter-over-quarter even though your balance sheet was roughly about the same, actually increased a little bit. Was there any particular driver that stood out as to why the interest income was down?

Peregrine C. de M. Broadbent

Nothing particularly. I mean, we -- actually, we had a much lighter dividend arbitrage season this quarter than we did in the second quarter last year. That actually took our interest income down. But there wasn't anything specific that would have driven our interest income down. And the balance sheet was actually very, very similar levels, and the balance sheet mix was very, very similar.

Operator

Your next question comes from the line of Michael Rogers with Conning & Company.

Michael Rogers

Could you please provide a little bit more color on any recent discussions that you may have had with the rating agencies and what might be their present concerns and what are they particularly happy about with respect to the way your business is going currently? And I'd love to get any color you might have on this ongoing review that Moody's has on some of the much larger institutions and how that could affect your ratings, if at all.

Richard B. Handler

I really can't comment on conversations that the rating agencies are having with other people. In regards to us, I think the rating agencies have been relatively straightforward in terms of asking us -- encouraging us to have reasonable levels of leverage, reasonable ratios of Level 3 assets, trying to do our best to have reasonable operating results and navigate through a relatively difficult environment. We are doing our absolute best to achieve all those objectives. It's not just for our bondholders' benefit but for our shareholders' benefit as well. We can't really worry about downgrades of other financial services companies. We have a very different operating model, and our objective is to basically stay liquid, use our capital for client flow versus proprietary trading and basically continue to balance all of our constituencies throughout the cycles.

Operator

Your next question comes from the line of Jeff Harte with Sandler O'Neill.

Jeffrey Harte - Sandler O'Neill + Partners, L.P., Research Division

Can you talk a little bit more about Fixed Income trading? Certainly, a 15% decline isn't good, but it's actually better than I was thinking and better than I thought some of the market metrics would have indicated. Were there any specific strengths to highlight in any businesses?

Richard B. Handler

I mean, there's nothing in particular. I just think across the board, our team has really established solid niches with our clients, and we're getting a reasonable market share. And across the board, from the rates, munis, mortgages, high grade and high yield, we've become pretty ingrained with many of the largest long only and hedge fund Fixed Income investors, and we're getting reasonable results even though it has been a relatively choppy period.

Jeffrey Harte - Sandler O'Neill + Partners, L.P., Research Division

Okay. The loss on your investments in managed funds, I suppose, given the way the markets actually were down kind of makes sense in the quarter. But anything to highlight there as far as big specific losses or positions?

Brian Paul Friedman

I mean, the number is less than 1% impact on our revenue. So it's not big. It's tiny. And as we noted, it's unrealized, so it's mark-to-market. I mean, we've had fluctuation and volatility there from time to time.

Jeffrey Harte - Sandler O'Neill + Partners, L.P., Research Division

Okay. And if you've given this before, I've missed it, but can you give us any insight or kind of outlook as to what the comp impact from the acquisitions and the amortization of stock replacement? Or how should we look at that going forward? It was what, a little over $9 million this quarter?

Peregrine C. de M. Broadbent

The comp impact for this quarter was $6 million over and above what we were initially anticipating and a couple of million or so in terms of what we were anticipating when we undertook the original acquisition. So in aggregate, somewhere between sort of $8 million and $9 million.

Jeffrey Harte - Sandler O'Neill + Partners, L.P., Research Division

Okay. Should we -- I mean, to what extent should we expect that to continue going forward?

Peregrine C. de M. Broadbent

We expect that there's going to be a similar comp number for the next couple of quarters in terms of a $4 million or $5 million number. But it's immaterial, and it'll be small. And by the end of this year, it'll become insignificant number.

Operator

You have a follow-up question from the line of Patrick O'Shaughnessy with Raymond James.

Patrick J. O'Shaughnessy - Raymond James & Associates, Inc., Research Division

I have a follow-up question on your Fixed Income trading. In past quarters where spreads have widened towards the end of the quarter, for example, the third and fourth quarter last year, you guys posted some Fixed Income trading losses in some areas, and I think your commentary was around your hedges may not have worked the way that maybe you'd expected them to work. Spreads blew out a little bit at the end of this last quarter, towards the end of May, and your Fixed Income performance was a little bit better relative to where it was in the last couple quarters of last year. So was there something about your hedges that maybe were more effective this time? Or was your trading performance just that much superior? Kind of what's the difference between now and what we saw late last year?

Richard B. Handler

I think what you're talking about really is the third quarter of last year when the treasury hedges against -- treasury shorts and corporate high grades completely went mismatches. There was a flock of demand going to safety, and that's when hedges wound up not working. The markets were not quite nearly as bad during this quarter at the end as it was at the end of August of last year. So I think it's just a magnitude of pain that was achieved back then relative to us being traders today.

Operator

There are no further questions at this time. I hand the program back over to management for any further remarks or concluding statements.

Richard B. Handler

Thank you, everybody, for dialing in today. Bye.

Operator

This does conclude today's conference call. You may now disconnect.

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