Jefferies Group Inc, Q2 2008 Earnings Call Transcript

Jul.22.08 | About: Leucadia National (LUK)

Jefferies Group Inc., (JEF) Q2 2008 Earnings Call July 22, 2008 9:00 AM ET

Executives

Richard B. Handler – Executive Chairman, Chief Executive Officer, President

Peregrine C. de M. Broadbent – Chief Financial Officer

Brian P. Friedman Esq. – Director, Chairman of Executive Committee

Analysts

William Tanona – Goldman Sachs

Ryan O’Connell – Citigroup

Michael Hecht – Banc of America Securities

Tony Della Piana – John Hancock

Horst Hueniken – Thomas Wiesel Partners

Tracy Noret – Merrill Lynch

David Trone – Fox-Pitt Kelton Cochran Caronia Waller

Patrick Dabit – Merrill Lynch

Steve Stelmach – FBR Capital Market

Operator

Welcome to the Jefferies 2008 Second Quarter Financial Results Conference Call. A question-and-answer period will follow management’s prepared remarks. (Operator Instructions) 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 the Jefferies Second Quarter Results discussion. 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.

In the face of a challenging market environment, Jefferies second quarter results improved significantly from those of a very difficult first quarter. Our net revenues for the second quarter were $392 million versus $201 million for our first quarter and $465 million for the second quarter of 2007. Our net income in the second quarter was essentially break-even, excluding approximately $15 million in severance cost, we were profitable for the second quarter. Our firm and our employees are not satisfied in any manner to report essentially break-even results, but given the unprecedented events of the past six months, and seemingly severe issues still faced by a number of our key competitors, this is material progress and we have worked hard to achieve it.

Our results for the second quarter show strength across our training platforms. Good results in asset management and solid revenues from the M&A and advisory offerings of our investment bank. Unfortunately, but not unexpectedly, capital markets, a significant driver of our prior year’s results, produced minimal revenues during the quarter. While our capital markets revenues were $136 million in Q2 of 2007, we recorded only $25 million in the most recent quarter. We expect to see a slow thawing of financing markets in coming quarters, but obviously, there are no assurances.

For the bulk of this decade, Jefferies has focused on achieving good short-term results while investing for growth. We did so with a singular goal of long-term value creation. This approach served us well, allowing us to deliver consistently improving results for over seven-and-a-half years.

The events of the past 12 months, however, have changed the environment in which we operate. As prudently and rapidly as we could, Jefferies has adapted our strategy to the challenges and opportunities that we face. Our strategy during the first half of 2008 was, first and foremost, protect and preserve our capital base and liquidity to assure our long-term viability.

We have always prudently managed our balance sheet and capital base; therefore, our firm never faced any liquidity concerns. However, given that our larger competitors suffered unprecedented losses and tremendous uncertainty, we decided to act decisively and preemptively to enhance our capital base to protect our franchise in these difficult times. In April, we announced and completed a common stock financing with Leucadia National which raised $434 million of equity.

During the balance of the second quarter, we carefully but deliberately liquidated the entire 10 million shares of the Leucadia stock we acquired as part of this transaction realizing in cash, slightly more than the amount of equity we had recorded. This equity financing has placed us in a very strong capital position.

At the end of the second quarter, we had in excess of $450 million of money market deposits, less than $20 million in short-term drawn bank debt, and average life of long-term liabilities of 14-and-a-half years, and no scheduled maturings on our long-term debt until 2012.

We are pleased with the quality of our assets and the fact that our balance sheet is not impaired by hung bridges, unwanted and delinquent securities, or complex synthetic securities. Basically we have over $4 billion of truly long-term secured capital and we believe we have fully achieved our first priority of protecting our franchise for the long-term.

That said, the second part of our strategy during the first half of the year was to closely monitor and reduce risk and eliminate peripheral businesses that entail risk with limited or delayed upside to our core business. We spoke a lot about this at the end of 2007 and again at the end of Q1 2008. As the turn-around in our results indicates, we have eliminated the poorly performing trading efforts in asset management teams we identified in Q4 and Q1.

The easiest way to understand where we are today in terms of risk is to know that our average daily bar in Q2, excluding the box shared trade with Leucadia, was $4.7 million compared to average bar of 8.1 million both in the second quarter of 2007 and for all of 2007, obviously, barred the risk metric with many limitations. But directionally (ph 00:06:30) it shows that we took aggressive action to respond to our new environment and together with our new capital raise, put our money to higher ground.

The third leg of (inaudible 00:06:44), which is not new is to preserve our long-term value and opportunity by retaining our primary assets, our people. In our business, most of the long-term investment we make is in the hiring of new employees as well as occasional groups of employees who, after a ramp-up period of some duration, become meaningful contributors to our results. A portion of our growth this decade is attributable to the results in operating leverage we have derived from people and businesses added to our platform. The cost of these hires and additions all flows through our quarterly results. During slower times like these, the cost of these ramp-up efforts will have a more meaningful impact on our results.

Through mid-2007, we successfully achieved the benefits of growing our platform. For the past 12 months including Q2, we have born some of the cost of growth without the full benefits. Our management team strongly believes in the positioning and potential of the Jefferies platform. To preserve our long-term value and opportunity, we are therefore making the judgment that retaining our key people and productive capacity is a top priority. To this end, we are continuing to accrue compensation of levels we think maintain our competitiveness. We have the capital base and the willingness to endure some period of mediocre results in order to position ourselves to emerge in an even stronger position when the current financial crisis passes.

Peg will address this further when he reviews our compensation and operating cost, but rest assured we are keenly conscious of the cost we are fairing. We will be as vigilant as we can to eliminate every marginal cost and reduce our break-even level whenever possible.

Beyond these objectives of assuring a rock-solid financial footing, reducing our risk, and preserving our human capital, the fourth and final element of our strategy is to play offense. We want to take advantage of the currents in our markets to enhance our strategic positions in our core operating business. As we have announced periodically throughout the first half of 2008, we have continued to selectively add key people to Jefferies who we believe can and will make a difference in our long-term trajectory. We have strengthened our core equities in our investment banking teams, added a significant group of professionals in merging sales and trading (ph 00:09:04) and other key hires in high-yield converts and fix-income as well as commodities and will soon be announcing a number of key hires in Europe, which we expect will transform our sales and trading of international equities.

In respect to our mortgage hires, I will note our pension for contrarian moves. When others are running from an asset class, we often take a look at what opportunities they may be leaving behind. In the case of Maurice sales and trading, we saw an opening for building meaningful presence in a business that is likely to operate on a rational risk-reward basis for the foreseeable future. We are extremely pleased that we are able to hire such a strong team of eight players in this asset class.

Jefferies will remain opportunistic for game-changers. Hiring or acquiring significant new personnel or business lines that will be virtually impossible to start or develop in times of normal markets and competition. We will do so prudently and patiently and while managing appropriately the risk. We are clearly making progress in executing our plan; however, there is no doubt that the current environment is still challenging and the markets remain highly volatile. This unprecedented environment has taken a modest short-term toll on all of us, but at the same time, we are embracing a new reality and doing our best to position ourselves emerged a much stronger and valuable company for our clients and our shareholders. As should be clear from what we are saying today, we have more than sufficient capital to operate and grow our business and are confident in our long-term future. However, in light of recent results, our board of directors has determined not to declare a dividend for this quarter. We have retained significant financial flexibility to capitalize on development in our business, possible growth or acquisition opportunities, and to repurchase shares pursued through our existing authorization having up to 15 million shares of common stock from time to time. Now, I would like to turn it over to Peg Broadbent to discuss our results in greater detail.

Peregrine C. de M. Broadbent

Thank you, Rich. As Rich said, from a top-flying revenue perspective, we had a very solid quarter, particularly in the light of the current market environment. We have net revenues of $392 million for the second quarter, a decrease of 16% versus the same quarter in 2007, which was a record quarter in terms of revenues. We recorded a loss of $4 million or $0.03 per share, which was primarily due to the compensation cost we incurred from our continued investments in human capital that Rich mentioned. Our compensation rate was 67% for the quarter, excluding $15 million of severance, or 71% including severance. Without this $15 million, our EPS would have been positive $0.03.

Overall, our second quarter net revenues of $392 million represent a 95% improvement over the first quarter of 2008. Fixed-income and commodities revenues, excluding high-yield, were $69 million, 72% better than the first quarter. Jefferies high-yield trading revenues rebounded nicely in the second quarter to $32 million as compared to -52 million in the first quarter.

Equity trading revenues improved to $149 million, up 12% compared to the first quarter. Investment banking revenues up 10% to $109 million as compared to $99 million in the first quarter. Advisory revenues were 85 million, which is a 29% increase from the first quarter. Our asset management results were positive, with revenues of $13.5 million for the second quarter as compared to a loss 28 million in the first quarter.

Non-comp expenses, excluding interest expense were 100 million this quarter versus 95 million in the first quarter. The increase is primarily attributable to some small non-recurring items. Our average headcount was 2327 employees for the quarter ended June 30, 2008, virtually flat versus the same period a year ago and down 3% from our 2007 year-end headcount of 2394.

Our effective tax rate for the quarter was 28% as compared to 35% for the second quarter of 2007. The unusually low rate for the quarter is a function of a modest overall increase in our state and local tax reserves, which increased our projected full-year tax rate. Note that our tax rate for the first six months of the year is now 39% as opposed to 38% for the first quarter.

Since the first quarter was a loss, the impact of the increased projected full-year tax rate was to increase the tax credit available that arises from these lawsuits. We now see the impact of this higher tax credit in the second quarter, and hence a lower than normal rate of 28%. We ended the quarter with 162 million shares outstanding. During the quarter, we made no open market repurchases.

We currently estimate our level three assets at June 30, 2008 to have been 345 million, which represents approximately 1% of our total assets. This should clearly indicate that the vast majority of our assets that are supported by more than 4 billion of long-term capital are price transparent and relatively liquid. Unlike the level three assets of many of our competitors, ours are comprised primarily of public and private corporate stocks, bonds, and loans which we own directly or through managed funds. We estimate that our gross and adjusted leverage ratios are 11 times and six times, respectively, both less than half the industry average. All these key liquidity indicators underscore the strength of our balance sheet and set us apart from our larger peers. I would now like to turn it over to Brian Friedman to discuss our investment banking and asset management results.

Brian P. Friedman Esq.

Thanks Peg. As Peg indicated, investment banking recorded revenues of over $109 million for Q2 as compared to 99 million in the first quarter. Advisory revenues of $85 million in the second quarter were up 29% from the first quarter and down 3% from the second quarter of last year. Capital markets revenues of $25 million in the second quarter were down 82% from the second quarter of 2007. Capital markets activity was extremely subdued in Q2, both in equity issuance and leverage finance across the streets, with the greatest activity being financial institution rescue financings, a part of the market we don’t yet serve.

During the quarter, Jefferies completed 22 transactions valued at more than $6 billion with four in high-yields, two of them lead-managed, 15 in equity, with seven of those being lead managed, and three lead-managed convertible financings. These financings included a $282 million secondary equity offering for Genco Shipping, a $221 million secondary for Central European Distribution Corp. in the consumer sector, a $125 million senior notes offering for Anchor Drilling in the energy space, and a private convert for Dynamic Green Energy in Cleantech.

Our advisory business, particularly our sector driven merger and acquisition business continued to operate at a strong pace, just slightly below the level of last year’s second quarter. Jefferies completed 36 advisory assignments this quarter valued at over $7 billion. Some transactions to highlight include a significant asset sale for Anadarko Petroleum and a $623 million sale for Chesapeake Energy, both prominent companies in the energy sector, as well as a $204 million sale of eScription in technology and a $286 million advisory assignment for Sony Pictures Entertainment in the media space.

Jefferies Finance, our joint venture with MassMutual continues to have a strong and liquid financial position. With the bank loan syndication market very choppy, we completed only three new deals during Q2, all of which were lead managed. However, the good news is the portfolio of mostly middle-market senior secured loans held up well. As a result, Jefferies Finance remained profitable during the second quarter of 2008 and has been profitable every quarter since we founded the business.

Looking forward, the quality of opportunities we are seeing is better than ever, and pricing leverage and covenance have become significantly more attractive for lenders. We expect to continue to underwrite sensible deals when we believe we can do so profitably. We believe our unique market position in investment banking will continue to strengthen. Competition from larger firms may be lessening as their own challenges cause some of them to focus their businesses in other direction. Consolidation of competitors, such as JP Morgan’s acquisition of Bear Stearns, should be very beneficial to Jefferies. In addition, as in the past, when Jefferies was able to add significant talent to our platform in times of trouble on Wall Street, we have made some key hires in the past few months with the intention to further enhance our exceptional team and best position our firm for the future.

Turning to asset management, our second quarter asset management revenues were $13.5 million, a good result after three negative quarters. On our past few earnings calls we have talked in detail about our evolving strategy for our US hedge fund seating platform. We remain committed to this business, but since the middle of last year’s fourth quarter, we have significantly reduced the amount of our capital at risk and have closed several underperforming US hedge funds. We have reduced the capital invested in managed funds from $390 million last year at the end of last year to $203 million at the end of the second quarter of 2008. As we continue to liquidate the remaining positions in one of our closed funds, this investment should decline to about $150 million in the next few months.

That said, we continue to provide full operational and marketing support for our remaining funds and are still considering talented management teams to partner with in the hedge fund space. In addition, during the second quarter, we have assembled an experienced group of professionals to offer a series of actively managed commodity strategies, which will be made available to clients later this year. Now I would like to turn it back to Rich.

Richard B. Handler

Thanks Brian. I would like to make a few comments about our sales and trading businesses, which had a record quarter, generating $250 million in revenues, a 109% increase over the first quarter of 2008 and a 14% increase over the second quarter of last year. Our equities business showed resiliency and strength in an otherwise challenging period. Our equity revenues for the quarter were $149 million, which is an increase of 12% over first quarter 2008 and an increase of 3% compared to the robust second quarter of 2007. Our customer equities business performed well and we believe we are beginning to benefit from the investments we have made in this core area of our firm over the past two years.

Our fixed-income and commodity revenues were at a quarterly record as the more than doubled over the first quarter and increased 72% over the second quarter of last year. Under the continued leadership of Tim Cronin, our fixed-income business was well-positioned to add value in an increasingly delinquent marketplace.

A few key hires during the quarter in our corporate bond trading group helped that business have an excellent quarter. And the addition of over 20 new senior professionals in the sales and trading of mortgage-backed securities made an immediate contribution to our results. Specifically, Johan Eveland, Bill Jennings, and the team they have assembled have done a phenomenal job of substantially increasing Jefferies presence in the mortgage trading business. And the addition of Tom Thees to the management of our department is already having a positive impact.

Jefferies high-yield trading rebounded with positive revenues of $32 million as compared to revenues in Q1 of -$52 million. In addition, we are very pleased to announce the addition of Rob Heart of Rob Harteveldt two weeks ago. After 24 years at Bear Stearns, Rob joined Jefferies as Chairman of Fixed-income. In working with David Schwartz and the other outstanding members of Jefferies high-yield and convertible team, Rob and a few other senior hires from Bear will enable our high-yield, distressed, and loan franchises to take advantage of the current market conditions and continue to develop our business. Rob will also work to help integrate our entire fixed-income platform.

The last 12 months have been the most challenging period I have experienced in my career. We are pleased to have regained positive momentum as affirmed in the second quarter. We believe the competitive landscape has never been better for our firm. We have built a foundation built on long-term capital, we are comfortable with the inventory and assets we own, and our culture is strong. Most importantly, as the health of our balance sheet and capital positions are not distractions, we can focus on our business and, more importantly, on our clients. We will balance the need to control cost and improve margins while continue to invest opportunistically in our platform. Our goal is to deliver solid long-term results for our employees and our shareholders. As always, we appreciate your support and we would be happy to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Guy Moszkowski with Merrill Lynch.

Patrick Dabit – Merrill Lynch

Good morning, this is actually Patrick Dabit (ph 00:24:06) from Guy’s office. Could you give us a little more color on the thought process with the board regarding the dividend cut given how comfortable you are with your liquidity and capital position.

Brian P. Friedman Esq.

It’s very simple. We are somewhat purists and in light of the fact that we didn’t have the earnings to cover the dividend, we felt that we should suspend the dividend, show our priority on both maintaining as strong financial position and on investing to grow our platform. Obviously we have the cash if we wanted to pay the dividend, but to the extent we did not earn it, we felt we should wait.

Patrick Dabit – Merrill Lynch

Okay, great. And then in terms of the strength in fixed-income and high-yield, could you give us some more detail in terms of what were the key drivers, specifically in fixed-income. And in high-yield, was it really just a result of some tightening of spread and reversing some of the losses you had seen there or was there some direction on that?

Richard B. Handler

I think on the fixed income side, we have enjoyed the benefits of increased market share, particularly in the cash business, which is what we really focus on. A lot of our competitors are not focused on the cash high-grade business and our team has just increased their market share. The mortgage team basically has hit the ground running and they have been basically able to trade effectively by virtue of not having a large balance sheet of inventory, so basically they’re positioned well to take advantage of the illiquidity and help our clients get liquidity. On the high-yield side, it was still a challenging quarter. I think we were pretty well positioned and we did have some rebound in some of our unrealized losses for the first quarter, but I think our general activity picked up on the secondary side as well.

Patrick Dabit – Merrill Lynch

Okay, great and then you mentioned the reductions were mostly related to poor performing teams, specifically in asset management, do you think you all have identified most of the cuts you need to make or could there be more?

Richard B. Handler

We think we did what we had to do and we are very pleased with our team.

Patrick Dabit – Merrill Lynch

Okay, great. Thanks a lot.

Operator

Your next question comes from the line of William Tanona with Goldman Sachs.

William Tanona – Goldman Sachs

Hey good morning guys. One thing you guys I do not think mentioned was the investment banking pipeline. Would you be willing to share kind of where your pipeline stands today versus where it may have last quarter as well?

Richard B. Handler

I mean it is basically driving us nuts. We have a great pipeline of capital market activity and we need a capital markets function capital markets to execute it. So we are gaining market share. We have a lot of great transactions in the pipeline and we need the financial markets to cooperate.

William Tanona – Goldman Sachs

Okay, fair enough. And then I guess in terms of compensation. You look at the compensation ratio even excluding the severance and you are still at 67%, I think. You know we look at revenues year-to-date. You are down 33% yet your comp and benefits excluding all this severance is up 7%. How do you kind of instill that culture of pay for performance when you see your kind of comp ratio going the direction it is? You know if I look at this quarter versus, say, the first half of last year, I mean your revenues are not that far off from the first quarter of last year; yet you put up to $0.42 ex-severance you guys would have put up $0.03. So it just seems the compensation costs are clearly what is driving the lack of profitability here more than anything else.

Richard B. Handler

Yes, I wish we could give a one sentence answer. It is a bit complicated. I think it comes down a combination of a operating structure that is built for the results that we achieved in the first half of ’07 continuing over a longer period of time. We have not necessarily downsized our platform to a lower level rather we have tried to maintain our capacity with a view that when the market does rebound we believe that our gains in share can be built on. And in fact, we can get significant growth.

So number one we are holding onto capability and effectively paying for it in the anticipation that we will benefit from it in the longer term. Secondly we do continue to make some very selective investments and as Rich said earlier, there is a payback period that is not immediate so we are absorbing a bit of that. And better times obviously it absorbs better. Thirdly and this is a difficult one to see in our numbers but small differences in the mix of revenue have an impact because there is a large portion of our firm that is pay for performance.

There is a portion of our firm that is on either fixed cost base such as the support functions or on a salary, bonus such as investment banking and a few other areas. The mix of where the revenue is relative to where those costs are can have an impact interplaying with the other things that I just described before. So it is a complex equation. We have prioritized holding onto our capability and being in a position to capitalize on upside. We are going to continue to look at our compensation structure and continue to look at our staffing levels but we have made a decision to make an investment with a view that over the next year or two as recovery takes place we will benefit.

William Tanona – Goldman Sachs

Okay and that was going to be the follow up I guess in terms of how long do you think you will kind of tolerate the excess capacity? You know it is anybody’s guess in terms of how long the market malays (ph 00:30:04) will last. But just curious as to how long you guys might be willing to tolerate this types of lower margins and returns in hopes that you will be poised to benefit when the markets actually do return?

Richard B. Handler

We are not complacent about it. We are working on it every day. I mean recognize that in the fourth quarter of last year and the first quarter of this year, we on the entire street saw some extraordinary events and circumstances. During that period, we made some changes in our structure and our personnel. But we focused heavily on balance sheet liquidity and writing the operating structure.

Now, in the second quarter into the rest of the year, there will be a heightened focus on the cost of operation and the cost of compensation. So do not assume that we are going to be complacent about it. At the same time, we are willing to tolerate some number of periods. I do not think we are ready to say today. We do not know when the turnaround is coming. We do know that we believe we have substantial staying power, very substantial.

William Tanona – Goldman Sachs

Okay. Thank you.

Operator

Your next question comes from the line of Ryan O’Connell with Citigroup.

Ryan O’Connell – Citigroup

Good morning. I wondered if you could talk just a bit more about the new initiative in mortgages. Maybe give us some idea of the scale and activity, the size of the team or whatever. And also maybe what kind of products that you are team is interested in trading. Are we talking about prime mortgages, subprime, Alt A, some color along those lines would be helpful? Thanks.

Richard B. Handler

In terms of the number of people we have hired roughly 20 people from a variety of firms. I think the total team eventually is going to be close to 35, 40 people. And they are literally trading every aspect of the mortgage business. These people have come from homes where they were expert in every single aspect of different classes of mortgage securities. And basically agency and non-agency, they making markets and they are providing liquidity.

Ryan O’Connell – Citigroup

And then – thanks that is helpful – is part of that due to a way maybe eventually to start originating mortgages?

Richard B. Handler

I think that is a long ways off for anybody to start thinking about that type of business. We do this very secondary trading operation. Obviously these people are capable of working on the origination side. But we have a large opportunity ahead of ourselves on the secondary side.

Ryan O’Connell – Citigroup

Okay, thanks.

Operator

Your next question comes from the line of Steve Stelmach with FDR Capital Market.

Steve Stelmach – FBR Capital Market

Hi good morning. You guys continue to manage your leverage relatively well bringing down quarter over quarter. Ultimately where do you expect or where do you want your leverage to end up and then secondly, on that topic, what sort of revenue impact should we expect for the lower leverage?

Richard B. Handler

We have never operated our firm based on optimal leverage in an operating environment to generate optimal ROEs. The bottom line is we are trying to get clear operating businesses that have real recurring revenues. And are not based upon massive amounts of leverage that are hooked up primarily to cash businesses. So we do not really think about it that way. We have been over capitalized for quite a few years and obviously the transaction with Lucadia we think we are in an even more secure position.

Steve Stelmach – FBR Capital Market

Sure, okay. And then just jumping real quick to the noncomp side. I know last quarter you mentioned that you were going to try to attack a noncomp expense. Yet it is up a little bit quarter over quarter. Do you guys still want to see some, some costs save on the noncomp? Or are you pretty much happy with the run rate you are at now?

Richard B. Handler

We are not happy with any of our run rate and costs anywhere throughout the organization. And we never have, we never will be. So we are looking everywhere to improve our margins.

Brian P. Friedman

As Peg mentioned there were a few small items in there second quarter versus quarter that were one time in nature. So we hope to be able to continue to work on that. Although recognize there is a big piece of the noncomp things such as rent and others that are relatively fixed costs and again, have to do with our desire to maintain our platform and our long-term opportunity.

Steve Stelmach – FBR Capital Market

Okay. And then just lastly on investment banking Brian. Whenever capital markets activity sort of picks up again where do you think, in the franchise, you are going to see the benefit? In what sectors or what products should we be focusing on? Or is it going to pretty much broad basing it?

Brian P. Friedman

The way we think about where we are in investment banking is that the strength of our immunative (ph 00:35:00) advisory business keeps us very excited because if you look at the investment banking business, the hardest piece of the business to build on and grow is the immunative advisory. That is the higher margin piece of the business and it is also the part that is heavily relationship and knowledge driven.

Capital markets, frankly, just come back. In other words, when capital markets strengthen we will get our fair share of it. Hopefully a bigger share than we have ever had and it probably comes back across the board. I mean, it is hard to predict right now but there is some argument that the high yield bond market may come back faster than the loan market but who knows. Similarly the convert market is a little better right now than the general equity issuance market on a proportionate basis. But last week, we did a couple of equity deals. It was a good week for equity issuance for us. So I would say pretty much across the board it will come back when it comes back.

Steve Stelmach – FBR Capital Market

Great. All right, thank you very much gentlemen.

Operator

Again, if you would like to ask a question please press star one on your telephone keypad. Your next question comes from the line of Michael Hecht with Banc of America.

Michael Hecht – Banc of America Securities

Hey guys. Good morning. How are you doing?

Richard B. Handler

Good. How are you?

Michael Hecht – Banc of America Securities

Pretty good. I just wanted to follow up on the question about the comp expense and maybe in a little different way. After last quarter, I thought that $300 million or so was the revenue number given for how we should think about the breakeven levels and here you are generating more like $400 million. And still I guess even if we exclude the severance kind of just modestly profitable. So kind of felt like you guys should have been able to generate more significant earnings at this level of revenue. So I guess the question is, is $400 million the new breakeven level? And what changed so much versus last quarter to add so much to the expense base?

Peregrine C. de M. Broadbent

Well, first of all we actually said that the breakeven costs loss was in the 300s not 300. So that probably clears up a misunderstanding as to what our breakeven point is.

Michael Hecht – Banc of America Securities

Okay, so $400 million is kind of breakeven. And anything over and above that we should –

Peregrine C. de M. Broadbent

No, not necessarily. I think as Brian said that the comp expense components of our expense base is fairly complex and to the extent there is a different mix of revenues which drives that comp expense component. It is very difficult to come up with an aggregated revenue number that would cover our costs, our fixed cost base.

I still say that in the 300s is our breakeven point. And again the mix of revenues driven by different divisions will have an impact on what our actual breakeven point is for any quarter, any given year.

Michael Hecht – Banc of America Securities

Okay. And then on the comp expense. Can you give us some sense of what percentage of your comp maybe is discretionary versus nondiscretionary? I think with all the hiring and guarantees you guys have offered. I mean nondiscretionary seems like it is a vast majority of comp expense which could limit your ability to manage that going forward.

Richard B. Handler

No, we will not give out the percentages but maybe what it is important to understand is that there are fixed compensation costs such as salaries and benefits and any commitments that we might make that are firm. There are then variable compensation elements such as commissions that are driven by formulas but are variable. There are then discretionary compensation elements such as bonuses which are driven by norms and competition and whatever indications we have given to our team.

So one of the, I think, challenges is that people want to look at fixed versus variable. There are really three components. There is fixed. There is variable. And then there is discretionary. And they apply in our case to our businesses, each of our business units in different ways. That is what creates some of the complexity and what Peg is describing about how are breakeven is versus compensation. It is kind of three dimensional formula encompassing those three elements.

Michael Hecht – Banc of America Securities

Okay. No, I got it. That is helpful. It would be helpful to kind of understand what the mix is but I got your point.

Richard B. Handler

I wish we could give it clearer. The mix is the mix. It moves around.

Michael Hecht – Banc of America Securities

Right okay. And then on the head count numbers, you guys kind of speak to the averages. Can you give us a better sense of the period and head count? The actual number of heads that were reduced since the end of Q1 and maybe the end of the year and then just the outlook for head count the rest of the year.

Peregrine C. de M. Broadbent

I think the period end head count was similar if not identical to the average but the course in what I mentioned. I would anticipate that throughout the rest of the year we will probably be operating at about that level of head count.

Michael Hecht – Banc of America Securities

And then moving onto the equity’s results. Nice quarter, 10% up quarter over quarter. Relative to GAAP P&L commissions seemed like they were down maybe 10% or so quarter over quarter. So I am just trying to get a sense of what were the drivers in the strong sequential and equities was at prime brokerage, was a good positioning. What else was going on there?

Richard B. Handler

I think the customer flow was exceptional. I think we had a good results in our outgo (ph 00:40:38) business and we are starting to get traction in prime brokerage.

Michael Hecht – Banc of America Securities

Okay and then is it possible to get more on the drivers of the fixed income results? How much of the $70 million was commodities, how much mortgages? I mean even generally just some sense of the mix.

Richard B. Handler

I think just generally the fixed income business was exceptionally strong and mortgages contributed. And those were the two main drivers.

Michael Hecht – Banc of America Securities

Okay and then just last question. Maybe just a broad thoughts on where we think we are in the fixed income cycle for high yield in particular. You know recap for us how you think you are positioned to weather the storm and at some point benefits particularly with the JV you have with Lucadia and what the benefits and costs of that arrangement are.

Richard B. Handler

Look it has been a very challenging last 12 months. That being said we have been through those periods of time, many times since the late 80s. I think we still have not seen a default cycle in any significant manner hit which could be something else that really could jar the marketplace. But assuming that does not happen I think high yields becoming more attractive some of the bank loans that people have put on over the course of the last few years with the covenant that put pressure on companies when they wind up not being able to have revenue growth.

So I think eventually you are going to see a new issue market come back. I think eventually you are going to wind up having reasonable flows into high yield as an asset class. I do not think that the – we really focus on the cash business versus the structure business. And we think long-term we are positioned extremely well given the fact that we have locked up money and we have a great niche and a great set of relationships to help facilitate and make trades and make money. So I am pretty optimistic about it. By the same token it is hard to be thrilled with the environment that has been as grueling as it has been over the course of the last several months.

Michael Hecht – Banc of America Securities

Okay. That is fair enough. Just one quick follow up on your comment on eventually flows coming back. Do you think that is more of a ’09 story versus some point second half ’08?

Richard B. Handler

I wish I knew exactly the day. If you do give me a call.

Michael Hecht – Banc of America Securities

All right. Thanks a lot guys.

Operator

Your next question comes from the line of Tony Della Piana with John Hancock.

Tony Della Piana – John Hancock

Thank you very much. Just the general question. Obviously the last few years we have seen some buoyancy in the markets. We have hit the other extreme here. I guess when things “normalize” what do you expect for your firm as a normalized environment sort of pre-tax margin? What do you think when things are all said and done, what you basically plan for in a normalized environment?

Richard B. Handler

We have spent the last 12 months whirling and dodging and weaving. So –

Tony Della Piana – John Hancock

So you got think about in terms of planning your expense base and everything. So I am just curious how you guys think of that?

Brian P. Friedman

We do. I think if you go back in time to ’06 and the first half of ’07. Our pre-tax margin was – I think it peaked out probably on a quarterly basis around – you can see it in the numbers. My guess is it was 25, 26% at the peak. To get into the 20s, ought to be very much our objective. The mix of our business when – depending upon how you define when the business is back. If capital markets is working, broadly trading is working and everything else is kind of okay. There is no reason we cannot be back into that kind of position.

I mean concept that is real. Are we managing toward it? You can see that our OP-X and again a lot of OP-X is fixed. It is not – it is down from the peak. It is not down dramatically but it is down from the peak and it is not creeping back up terribly much. The comp is really going to be the driver and as we have said before we think we can work on it. So I think you can go back and look at 2006 and early 2007 and say why cannot we get back there? It will be different but we can get back in the neighborhood.

Richard B. Handler

The other side is to it is every time we have been through one of these periods as a firm. And we have been through it in 90, 94, 98 and 2001. Our goals of the firm is to emerge, once this happens, with core incremental operating businesses and partners that we did not have before the dislocation occurred. And just like in 1990 with high yield or investment banking or with the commodities group, we made a number of key investments which all potentially help us increase our margins when we come through the cycle. By the same token we are just looking to weather the storm right now and really drive margins once things have stabilized.

Brian P. Friedman

Given what has happened with our competitors and what is going on in the world. You could get happy about the second quarter but you cannot get happy about breakeven results. We have got to deliver profitability. We need to see a little better environment to really get it going.

Tony Della Piana – John Hancock

In terms of the, obviously the second quarter your results were significantly better than looking at the other folks in the market. Can you tell us number of trading day losses and any flavor in terms of the size of those type losses? So was it consistent with previous quarters, a lot of trading day losses but very minor so you were not rolling the dice a little bit in terms of these nice uptakes in performance.

Richard B. Handler

As evidence by what we mentioned about the VAR (ph 00:46:43), our risk levels for the quarter were lower. Now, in fact, we did have –

Tony Della Piana – John Hancock

But that is a problem because no one is waiting the VAR towards the recent performance. So are you still looking at five years history, three years history of price moves that really – the VAR using those assumptions does not give you much of a flavor –

Richard B. Handler

Peg will address the specific daily loss experience.

Brian P. Friedman

It is going to be in our Q in detail right.

Peregrine C. de M. Broadbent

Yes. It will be in the Q as it always is. We know VAR is not a perfect measure as Brian and Rich indicated. Our VAR did come down and the correlation with that is we had significantly fewer days – loss making days during the quarter than we did in the first quarter. All the details will provided in the Q which we will publish at the beginning of next month.

Richard B. Handler

I think the headlines when you see the dispersion you will see that our core operating businesses were actually peaking in as opposed to taking advantage of risks and getting lucky in the marketplace. So that is not what happened for the quarter.

Tony Della Piana – John Hancock

Thank you.

Operator

Your next question comes from the line of Horst Hueniken with Thomas Wiesel Partners.

Horst Hueniken – Thomas Wiesel Partners

Good morning. I noticed that your level three assets have risen from $269 million to $345 million in the latest quarter. Is this a reflection of a deliberate effort to gain market share and how should we think about what the go forward level might be?

Peregrine C. de M. Broadbent

The level three assets have grown as a function of a loans business that we operate that turns over. In principle really operates as sort of an agency business but the way in which the accounting works is such that we gross up the buys and sells before the loans close. And it just so happened that the end of this particular quarter we happened to have a lot of pending loans on our books. There is no actual risk associated with those particular loans and when they close out this particular number will fall. So I would not necessarily anticipate this being any sort of strategic trend or any deliberate process to increase risk –

Richard B. Handler

It is a business of secondary trading of loans. And so we take a loan onto our books and at that same time, we have an agreement to trade it off but until that clears it does not go out of our books and it falls into level three.

Horst Hueniken – Thomas Wiesel Partners

Understood, that is helpful. In regards to the revenue of about $142 million from your principle trading, are you able to breakout the major components of this revenue figure just to help us out assess sustainability?

Peregrine C. de M. Broadbent

Well, we actually disclose on our revenues by source. The combination of both principle trading and commissions an aggregate by major divisions. So if you look at the supplement to the earnings release I think most of the information that you are asking for is actually split out.

Horst Hueniken – Thomas Wiesel Partners

Okay fair enough. That is all for me. Thank you.

Operator

Your next question comes from the line of Tracy Noret (ph 00:50:24) with Merrill Lynch.

Tracy Noret – Merrill Lynch

Good morning. I have a question regarding your private client group. Could someone provide some color on the status of the group? Are you building? Are you cutting back? And where is that group heading? Thank you.

Richard B. Handler

I think we are continuing to have a very focused PCS business where we are focusing on larger, high net worth individuals. We are working on developing a mid-market’s calling effort and we are integrating them with our equity effort. So it is pretty much as we have been discussing over the course of the last few years. Nothing has really changed dramatically.

Operator

Your next question comes from the line of David Trone with Fox-Pitt.

David Trone – Fox-Pitt Kelton Cochran Caronia Waller

Good morning. I just had a quick question on the – there was a question earlier that presumed guarantees and you guys did not dispute it. And there has been some kind of discussion on the street about that too. But I know a lot of the boutiques are not paying guarantees. Can you address that issue?

Richard B. Handler

Yes, we did not dispute it. We did not agree with it. We are not responding specifically to that point. We occasionally have to make commitments in the context of people making changes and joining us. I do not think it is a defining theme of our firm or of our compensation structure. There is competition still for exceptional people and we will make commitments from time to time as appropriate.

David Trone – Fox-Pitt Kelton Cochran Caronia Waller

Is that more the case with international and fixed income folks versus US equities?

Richard B. Handler

It is on a case-by-case basis and the reality is the competitive landscape has never been better for us to attract quality people. By the same token there are competitors out there trying to get each one of the top quality people we are after. But the magnitude and amounts of guarantees throughout our organization do not have a material effect on our actual comp ratios and our ability to bring more agents down to the bottom line. Money is not the bottom line.

David Trone – Fox-Pitt Kelton Cochran Caronia Waller

Okay, great. Thanks a lot.

Operator

At this time, there are no further questions. Are there any closing remarks?

Richard B. Handler

Thank you everybody and have a nice day.

Operator

This concludes today’s Jefferies 2008 second quarter results financial conference call you may now disconnect.

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