Jefferies Group Inc. (JEF) is one of the few remaining traditional investment banks that's unique attribute is its experienced personnel, led by its under-rated CEO Richard Handler. While the valuation might not be quite as attractive as some of its larger peers, this is a better run company in my estimation, and its smaller size should enable it to grow at a faster rate.
The company survived a near-death experience last year, when concerns about the European crisis hit its zenith and a misleading and flat-out inaccurate research report by Egan-Jones dramatized Jefferies credit risk. As an investment bank Jefferies provides fundamental research and trade execution in equity, equity-linked and fixed income securities, including bonds, mortgages, various types of loans, commodities, derivatives, and securities financing. In addition the company has a robust capital markets business that is well positioned in M&A, restructuring, and financial advice. Jefferies is also trying to grow its asset management services like some of the other larger banks. Because of the dismal economic environment Jefferies' core businesses have posted very average returns. As the world keeps on turning and as economic growth eventually musters steam, Jefferies earnings per share and valuation are likely to climb significantly.
In fiscal year 2011 Jefferies posted revenues in excess of $2.5 billion, net income to common shareholders of $285MM and EPS of $1.28. While these numbers were far from stellar, when one thinks back to the environment post MF Global when Jefferies was looked at as the next domino to fall, it was truly a testament to excellent management that the company was able to emerge from the crisis profitably, and ultimately end up as a "White Knight" for Knight Capital Group Inc. (KCG) this year. The company survived by providing unparalleled transparency of trading positions and liquidity, reducing leverage, and through articulating effectively that the hysteria generated by the erroneous Egan-Jones report was not warranted based on the actual positions. Due to the consolidation in the investment banking industry, and investments to increase staffing, Jefferies is winning market share in most of its primary businesses. Because it's not a traditional bank, Jefferies hasn't seen the benefit of increased mortgage refinancing or reductions in loss provisioning which have helped other banks earnings, just as they hurt these banks to a far greater proportion than Jefferies during the financial crisis. For Jefferies' true earnings power to shine, capital markets activity must pick up steam. That means more M&A, more IPOs and increased trading volumes. While it isn't likely to get too much better in the short-term, this uncertainty is why the investor has the opportunity to acquire this solid firm at a bargain price.
Jefferies 3rd quarter earnings were only fair at best. The company had net revenues of $739MM, net income to common shareholders of $70MM, and earnings per share of $0.31. Jefferies engineered a very lucrative restructuring for Knight Capital Group where it gained a large ownership position, and its impact to net revenues and EPS was $103MM and $0.08 respectively. Market making has always been a core competency of Jefferies, so while the business might not be as lucrative as it once was, the relationship with Knight should work out quite well primarily due to the bargain purchase price. Investment Banking revenues were $260MM compared to $294MM in the 3rd quarter of 2011. Capital Markets revenues were $127MM and M&A and Advisory revenues were $133MM. Fixed Income revenues were $266MM, up dramatically from $33MM a year ago when concerns about Europe froze up market activity. Equities net revenues were $210MM including Knight Capital Group.
On the expense side Jefferies' compensation expense ratio was close to 60%. While this number is higher than what the full year number will likely turn out to be, Jefferies and other banks need to be a little more realistic in how they are treating shareholders. The employees aren't risking their own capital, and while they should be compensated fairly this seems quite excessive, and frankly I can understand why investors wouldn't want to be partners in this sort of an equation. I understand that talent has other options, but Hedge Funds haven't exactly been knocking the ball out of the park, and every bank is laying off people, so now seems like a reasonable time for the Board of Directors to reign in this dysfunctional structure. Non-compensation expenses should continue to head lower as investments in technology and infrastructure have likely peaked in prior quarters.
During the quarter Jefferies purchased 1.7MM shares at an average price of $12.67, which should be quite accretive when considering book value and adjusted book value is $16.59 and $15.63 respectively. The company has another 11.5MM shares left on its buyback. After last year's scare, Jefferies has cut leverage considerably to 9.3 times. One reason Jefferies is one of my favorite names in the space is the relative balance sheet transparency, where only $436MM of assets are defined as Level 3. Jefferies believes that it has a liquidity buffer of $4.2 billion, with $2.8 billion consisting of cash, and $1.4 billion in unencumbered liquid securities. Richard Handler made a good point in the earnings call by arguing that the company is not reliant on wholesale funding, because instead it uses secured assets. This is very different than when prior to the financial crisis, banks and other financials were relying on unsecured funding sources, which of course are the first ones to freeze up.
An investment in Jefferies is one of the purest plays on long-term improvements in the capital and investment banking markets. Companies are going to still need access to capital and fewer participants combined with excellent talent enables Jefferies to gain market share. Strategic investments such as the Knight Capital Group example have a very material impact on Jefferies, and I'm comforted by the presence of Leucadia National Corp.(LUK) as the largest shareholder and on the board of directors. This is another key differentiator between Jefferies and the other larger banks, in that Lecuadia has one of the finest investment track records over the last 30 years, and they are hugely incentivized to assist Jefferies in creating shareholder value. Jefferies should be able to eventually earn 13% on equity once the macro-economic picture improves. This would put normalized earnings power at around $2.10 per share, but with accretive share buybacks and the retention of earnings this number should grow at a reasonable rate. Looking 3-5 years out Jefferies could certainly trade at 1.2-1.4 times book value reflecting its more attractive growth prospects, and the possibility of being acquired by a larger firm. The company has proven it can operate profitably even in the most challenging environments, so the patient investor really doesn't need multiple expansion for this to be a successful investment because of the cheap price being paid. One strategy that an investor might use is to sell the $15 January 2014 puts for $3.10. Assuming the stock closes above $15 at expiration, the target profit would be about 26% on the maximum risk of $11.90. Obviously the breakeven price of $11.90 provides an even greater margin of safety than buying the stock at the current price of $14.52.
Disclosure: I am long JEF.