Leucadia National's Game-Changing Strategy

Summary

• The management team at Leucadia announced a major shift in the company's business model on April 9th.
• The firm is selling off a large piece of National Beef, as well as other assets, to focus in large part on its financial services operations.
• As part of this, its share buyback program has been doubled, and the firm doubled down on its oil and gas business under the Vitesse name.
• Management also intends to change the entity's corporate name to Jefferies Financial Group Inc.

The management team at Leucadia National Corporation (NYSE:NYSE:LUK-OLD) is hard at work transforming the business. Long referred to as a mini-Berkshire Hathaway (BRK.A, BRK.B), the conglomerate has spent several years building up its business and diversifying it, but this latest transaction will move in the opposite direction, divesting of some significant assets in order to benefit shareholders by generating value that can be applied elsewhere. While volatility stemming from economic activity will magnify, the likely result will be positive for long-term investors.

Management is selling off some big assets

Shares of Leucadia soared to close up 11.6% on April 9th. This move higher added nearly $900 million to the business’ market value and is based in large part on management’s decision to sell off a sizable piece of the company's stake in National Beef. Last year, the business, of which Leucadia purchased 78.9% for $868 million more than 6 years ago, generated $7.36 billion in revenue.

This places the firm as the fourth-largest US beef company by sales with a 12.5% market share. Only Cargill, JBS, and Tyson Foods (NYSE:TSN) are larger. It’s also the largest US exporter of chilled beef, and is the second-largest US hide tanner with a roughly 27% market share. According to management, 92.7% of the company’s revenue comes from boxed beef and beef by-products.

To benefit from the future growth of the company, management decided to retain 31% of its equity, meaning that management will be divesting nearly 48% of the business to Marfrig Global Foods S.A. (OTCPK:MRRTY), which will also be acquiring 3% in equity from other owners of the business. Total cash received from the sale will total around $900 million, valuing the entire business at $1.875 billion (but with a $2.3 billion enterprise value). However, between now and the time the sale is completed, management expects to extract a further $150 million from the business.

On the whole, the acquisition of its stake in National Beef had been a wise move. Since its purchase of a majority of the business, Leucadia will have received cash distributions from the firm equal to $1.6 billion. Add to this the nearly $590 million that its 31% remaining stake will be valued at, and the firm’s investment, inclusive of returns, will have totaled $2.19 billion. That represents an increase in value of about 16.7% per annum.

Besides National Beef, management also included in its announcement the fact that it had reached an agreement with the Garff family, whereby Leucadia will divest to it 100% of its equity interests in Garcadia, its automotive dealer group (and related assets). As of today, Garcadia owns and operates 28 domestic and foreign dealerships spread across 4 states. As part of its arrangement with the Garff family in the past, 65% of the operating cash flow would always flow to Leucadia, while the remainder would flow to the new buyers of its piece of the business (there are five dealerships where the rules diverge from this approach, though).

Last year, Leucadia received $45.3 million related to cash flow from Garcadia, as well as $9.5 million in lease payments, but this is a small amount of cash to forgo considering that the business will receive $425 million in consideration from the sale. This will consist of $375 million in cash, plus $50 million in the form of redeemable preferred equity. This all excludes what cash can be pulled from the business between now and the time the sale is completed. Considering management acquired the stake in 2006 and made continuing investments during that time frame for total capital committed of $321 million, the sale plus the $394 million in cash the company has generated from the business during its ownership implies a respectable return of 8.1% per annum.

Leucadia’s focus is shifting to financials

Besides its revenue associated with National Beef, the largest piece of Leucadia’s business is its ownership over Jefferies. Sales for the segment have soared in recent years, growing from $2.48 billion in 2015 to $3.21 billion last year. This increase in sales was driven by a number of factors, but was chiefly attributable to the company's Equities and Fixed Income businesses, as well as by the Debt business of its Investment Banking arm.

*Taken from Leucadia

Through its Equities business, Jefferies facilitates trading in equities and generates revenue from sales & trading operations, prime services, and wealth management. Its Fixed Income business does much the same, but focuses, naturally, on bond issuances, asset-backed and mortgage-backed securities, high-yield and distressed securities, bank loans, emerging markets debt, and more.

*Created by Author

On the Debt side of its Investment Banking business, the firm engages in the actual issuance of debt securities for companies, while the Equities side does the same for stock. As the table above, which breaks out the number of transactions Leucadia completed and the amount of capital raised by the business for its customers in each of the past three years, shows, Investment Banking is really just a numbers game. Like the company’s trading-based businesses, it should benefit from increased economic activity and it will be punished by decreased economic activity. This places Leucadia’s long-term success right in the hands of the global economy, removing some of the protection that National Beef provided.

*Taken from Leucadia

Some investors might point out that, while sales growth for Jefferies has been attractive in the recent past, the bottom line results for the business have a history of extreme volatility. In the image above, you can see that 2016 saw only $43.51 million worth of pre-tax segment profit, while 2017 saw a profit more than 12 times that. Certainly, in times when decreased economic activity arises, the business will suffer, but it’s worth noting that a continued upswing in what are already good times should bring attractive wealth generation.

*Created by Author

In the table above, for instance, you can see three key cost categories for Jefferies. Not only have floor brokerage and clearing fees fallen relative to sales, but compensation and benefits, as well as selling, general and administrative costs, have declined as well. Given the size of these changes, it appears to me that the business has the ability to scale up in a cost-efficient manner, but the opposite will also hold true if activity falters.

Outside of these operations, though, Leucadia does have various other financial services-related businesses. Perhaps the most interesting is the firm’s Berkadia Commercial Mortgage LLC business. Founded years ago as a joint venture with Berkshire Hathaway, Berkadia originates and sells mortgages, and keeps some on its own books. This, which operates under the Jefferies segment, as well as the various businesses (oil and gas, manufacturing, and consumer products [the latter of which come from its stock ownership in HRG Group (NYSE:HRG)]) that fall under what management calls its Merchant Banking Businesses and Investments operations, provide upside for shareholders.

The plan moving forward

By management’s own admission, Leucadia is shifting its focus away from National Beef and toward financial services as a long-term play. As a sign of its commitment toward this new strategy, the business has decided, pending shareholder approval, to change its name to Jefferies Financial Group Inc. This does not mean that the firm will not invest in other, non-financial, operations (the firm announced in the same press release that it had Vitesse, one of two oil and gas businesses it is invested in, to buy up Bakken acreage for $190 million - more than doubling its geographic footprint). However, it should be expected that financial services will be an even larger focus of the business in the years to come.

Seeing value in the enterprise and wishing to reward shareholders who have remained loyal to the business, management decided to increase the size of its share buyback from 12.5 million shares to 25 million shares. If completed, it would amount to more than $600 million at today’s price and would represent around 7% of all shares currently outstanding. Not only is this decision driven by the amount of cash the business has coming from these sales, it’s also likely driven by what the sales mean on a book value basis.

*Taken from Leucadia

In the image above, you can see that, following the completion of the various transactions it announced and after adjusting for taxes, Leucadia’s book value will have risen by $1 billion, growing from $10.1 billion to $11.1 billion. On a per share basis, this implies a value today of $31.20, compared to the $28.35 shares were worth at the end of 2017. With the stock at $24.29 apiece, there’s an opportunity for investors who find the business appealing, but given its large financial services exposure and the volatility the business has seen in the past, it might be unreasonable to expect shares to trade at a meaningful premium to book value.

Takeaway

As an analyst, I like seeing innovative transactions by companies like Leucadia. Given its large exposure to beef, this is truly a transformative move by management, as not only does it increase the company’s book value by realizing value from its assets, but it also streamlines the business to focus on where management sees the greatest opportunities. My own view is that over the long haul this will prove beneficial for Leucadia, but investors should expect this to come at a cost in the form of higher volatility whenever the economy takes a downturn.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.