I like investing in businesses with strong management, a large margin of safety, and a relatively clear path of producing robust shareholder returns. The morbid bear market of 2022 has created many attractive opportunities for investors willing to take a long-term perspective. Jefferies (NYSE:JEF) is a well-run Investment Bank that has been gaining market share, returning capital to shareholders, and which trades at a large discount to intrinsic value. The macro environment is terrible, but as Warren Buffett says, “you pay a very high price in the stock market for a cheery consensus.” Capital markets will improve, and the bear market will likely end before we actually are out of what seems like a rather inevitable recession. Jefferies will be primed to capitalize on that recovery with a management team that also knows how to take advantage of a discounted stock price via stock buybacks.
Jefferies Group has been patiently built over the last 60 years, with CEO Rich Handler joining the company in 1990 and becoming CEO in 2000. Jefferies was averaging $359MM in revenue and $35MM in net income in the 1990s, growing to $6,197B in revenue and $1,261B in net income in the 2020s. Investment Banking net revenues were $9MM in 1990, growing to $4,163B in the TTM ending in Q3 2021, resulting in a 22.1% CAGR. The company has achieved this by focusing on meeting the needs of its clients and investing in people. The company is conservatively financed with strong liquidity and risk management. As of May 31st, 2022, the Leverage ratio is 5.5 and the Tangible gross leverage ratio is 6.6. The company is really focused on increasing the proportion of income that is derived from lower risk and less volatile activities, such as asset management, while exiting its legacy Merchant Banking portfolio over time. Strong management prioritizes returning excess capital to shareholders through dividends and mostly accretive buybacks.
In 2004, Jefferies formed a 50/50 joint venture (JFIN) with MassMutual, focusing on arranging leveraged loan transactions and managing a loan portfolio. The JV has arranged $275B of loans since inception and is the manager of 24 term loan and revolver CLOs, with $12B of managed capital. The JV generates attractive fee revenues, while also feeding the Investment Banking franchise. JFIN produced $271MM in pretax income in 2021.
In 2009, Jefferies established a 50/50 joint venture with Berkshire Hathaway (BRK.B) forming Berkadia, which is a full-service commercial mortgage banking firm offering loan financing solutions, investment sales advisory and mortgage servicing. Since 2009 Berkadia has distributed over $736MM in cumulative cash dividends to Jefferies. Berkadia has a $317B servicing portfolio, originated over $32B in new financings in 2021, and brokered $16B in CRE sales transactions in 2021. Berkadia produced $292MM of pre-tax income in 2021.
Jefferies partnered with the Japanese bank SMFG, where it will attain financing to enable it to grow the number of transactions originated by Jefferies, while also increasing its penetration of Japanese corporate clients seeking global advisory services. Since Jefferies has not converted to a bank itself, it does not have access to the low-cost deposits of some of its investment banking peers, so this relationship is helpful to improve the reach of the company.
Pandemic Era Winner
Jefferies was a major beneficiary of the robust capital markets environment that occurred during the pandemic/lockdowns of 2020/2021, posting seven quarters of core business earnings higher than any quarter before 2020. Jefferies is the 6th ranked global M&A advisor, 8th ranked in Cash Equities, and is top ranked in the US in LBO loans. While the environment was beneficial, it is important to note that Jefferies exceeded market growth by strong margins in Investment Banking 16% vs. 28%, Equities 8% vs. 35%, and Fixed Income 14% vs. 37%, from 2018 to 2021. This is seen in improved market share in these key businesses. Jefferies has seen excellent growth in its Leucadia Asset Management business, growing its aggregate NAV-Equivalent AUM from $10B in 2018, to $22B in 2021. This business will continue to grow in importance as the company focuses on enhancing fee revenues. Jefferies still has a nearly $2B Merchant Banking portfolio with large businesses in oil and gas, and real estate, among others. Over the last 9 years, the company has recognized $2.4B in aggregate pre-tax gains from the sale of 11 businesses, with the largest profit of $1.1B coming from National Beef. In 2021, Jefferies generated $7.1B in net revenues, including $4.4B in Investment Banking revenues, and generated $1.7B in net income.
Recent Quarterly Results
On June 27thJefferies announced net income of $114MM, or $.45 per share. This was down substantially YoY from $352MM, or $1.30 per share as capital markets were far tighter during this tumultuous bear market. New issue volumes were extremely limited, and the company took some unrealized markdowns in mortgage inventory and leveraged finance commitments. The annualized return on adjusted tangible equity was only 5.8%, down from 19.2%. Investment Banking and Capital Markets revenues of $1,098B and Total Net revenues of $1,369B were down 31% and 30%, respectively. The company repurchased another 8 million shares of common stock for $258MM at an average price of $32.20 per share. As of May 31st, 2022, JEF had 232.3MM shares outstanding and 259.6MM on a fully diluted basis. Book value per share was $44.34 and tangible book value per share was $33.36. Jefferies pays a quarterly cash dividend of $.30 per share, which is good for a 4.3% dividend yield at the recent price of $27.90. The company has repurchased 145.3MM shares of common stock for $3.4B, or an average price of $23.16. In total, the company has returned to shareholder $4.6B, or 46% of shareholders’ equity and 61% of tangible shareholders’ equity on January 1, 2018.
Management pointed to a strong backlog and market position, but the execution will be quite conditional on normalizing economic and market conditions. Companies still need to issue equity and debt and Jefferies has built strong relationships to become a trusted source for that. We could start to see M&A pick up as well in the 2nd half of the year, as stronger companies attempt to consolidate their position and take advantage of cheaper equity prices. I think it is very likely that the economy will be or is already in a recession, and the stock market is pricing in that possibility. Jefferies stock has come down dramatically from its high around $43 last November.
At $27.90, JEF trades at 63% of book value and 83.6% of tangible book value. Using a 10% normalized ROTE puts earnings at around $3.36, which would put the stock at about 8.3x – a very conservative metric for earnings power. With a market cap of just under $6.5B, Jefferies outperformed dramatically in 2021 generating $1.7B in net income, so we are talking about a low multiple on what could be trough earnings in 2022. The balance sheet is in good shape and management absolutely has the opportunity to take advantage of the cheap stock price by buying back stock, which would be highly accretive at current levels. With 4.3% dividend yield, investors are being paid to wait for capital markets and Mr. Market’s mood on the stock to improve. I believe the stock is conservatively worth about $35 a share, which is around where I see tangible book value per share being at the end of the year, with upside beyond.