Value Investing

The Stock I Like Best: Leucadia National Corp. (LUK): Valuation Analysis

The Stock I Like Best: Leucadia National Corp. (LUK) by Remick Capital

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Summary:

From time to time the market hands investors an apparent opportunity in which the facts on the ground about what a business is worth, seem to deviate from market price driven estimates so much that you will find yourself looking around in confusion, asking “what am I missing?” Leucadia National is, for me, one such investment at today’s price.

There are many reasons which I believe cause the stock market to discount future possibilities at Leucadia, but the pessimism which permeates Leucadia’s valuation seems short term, and overdone; missing the many positives of the company. Also, I believe there are non-fundamental, emotional and short-sited reasons many legacy holders of Leucadia are throwing in the towel – maybe because they are sad the old leaders are half out the door, or perhaps because they need to realize tax losses this December. I believe their lack of fortitude in combination with Leucadia’s many cyclical business lines currently under earning their potential, is creating a once in a generation opportunity to buy a quality business with great management at a large discount to tangible net assets.

Leucadia History:

In 1978, Joe Steinberg (JS) and Ian Cumming (IC) took over Talcott National, a 125 year old (mostly) factoring business, which was a struggling company with a negative net worth at the end of 1978. By mid 1979, JS and IC had completed a restructuring of Talcott and subsidiaries by extinguishing approximately $160m in debt with $130m in capital that was raised primarily by selling financial subsidiary assets. Through this move and a few others, Talcott moved from negative $8m in equity in the business at the end of 1978 to nearly $30m in equity by the end of 1979. From that auspicious beginning, IC and JS took Leucadia National, newly renamed in 1980 with the sale of the factoring business, on a run of acquisitions, divestitures, restructurings, and various business deals that would culminate in a company at the end of 2012 with one of the great capital allocation records during that timeframe of any public business; compounding shareholders equity per share at greater than 18% / year (including dividends).

Characterizing IC and JS’s style of management during this 3 decade run is not hard. They tried to buy cheap, distressed, and sometimes mismanaged assets. They would clean out and restructure these assets, take care of them for a time, and then when the time was right, sell to a buyer when the fog of war was gone and the assets were no longer as distressed.

They did hold some of their businesses for the long term, but in general, they excel(ed) at buying what no one else was willing to pay up for, seeing value where others didn’t, buying where others feared to tread completely, and importantly, leveraging extensive knowledge of the tax code to ensure Uncle Sam’s profit share was reinvested as long as possible.

During this time, JS and IC didn’t have conference calls, rarely were captured in the media, and largely flew below the radar in the investment community and Wall Street. Once each year, Leucadia published a short and informative investor letter with their annual report, and had a short annual meeting with shareholders. They attracted a loyal following of shareholders who profited from their eclectic vulture-like approach to capital allocation and mostly stuck to their knitting.

A sampling of transactions from 1980 to around 2010 is captured below; I provide this only for clients who don’t have a good idea of the scope of activities Leucadia has been involved in over the decades, I’m sure many pertinent items were missed:

1980-1982 – Sold Talcott Factors, bought AIC (insurance), sold roughly half of consumer finance receivables for $200m, bought 57% of TFI (building products and meat product distribution), and sold a ton of company owned real estate.

1983-85 – Repurchased $4.5m in stock, entered into partnership with Jordan company (PE firm), bought Columbia National Life, received bank license (Utah), bought Conwed (for $45m) via TFI, bought leasing services via Ch 11, bought stake in Brae Company (leasing), bought minister, GATX, and Prudential.

1986-88 – Bought back $20m of LUK stock, sold $140m in bonds, added $25m bank line, sold consumer finance operations, sold Ministar, sold 1/3 interest in Carmike via IPO (owned via Jordan Company investments), bought back $10m more in stock, bought Phlcorp (trading stamps and other assets), reached $2B in assets, began to temper expectations of returns, and highlight complexity.

1989-1993 – Sold railcar leasing biz (basically all of Brae) for a gain of $47m, bought back $37m in stock, cuts loose legacy traditional life biz, realizes $17m loss, bought Colonial Penn for ~$130m, Colonial Penn earns $191 pre-tax income 3 years later, sold $125m of notes, rated investment grade for the first time (Jefferies handles the deal), floated $100m convertible notes, resolved El Savadoran electricity subsidiary, realized gain via cash and bonds from El Salvadoran government of $8m, realized $13m gain in Bolivian Power IPO (gained shares from Barbados Power & Light).

1994-1999 – Began a RE buying spree (two Ch11 transactions, buying HomeFed, etc), entered into Wine business, invested $25m in Russian driller, grew and then started winding down insurance business as it was unprofitable, acquired some pre-Inmet assets, liquidated / sold all manufacturing assets except Conwed, had a failed investment in Russian Pepsi bottling operations, repurchased $50m face of preferred stock for $40m, added real estate via Home Fed in San Diego and Washington DC, and paid a large one time dividend.

2000-2006 – Acquired FINOVA in partnership with Berkshire Hathaway (Berkadia), entered into Jefferies credit hedge fund partnership, acquired WilTell and then sold to Level3 for large gains, warned of housing market mortgage problems in 2003, bought Symphony Health, warned about supposedly AAA rated companies having issues with Fraud in 2004 (cited MBIA, AIG, Fannie Mae and Freddie Mac by name), acquired Idaho Timber, MK Gold stake upped and converted into Cobre Los Cruces investment in Inmet, and made Fortescue investment + follow on purchase while discussing that China was driving much of their recent commodity exposure.

2007-2010+ – Took stake in Goober Drilling, bought into Premier Gaming, wrote off tax asset, and then later wrote it back up, invested in Lake Charles Gasification project and Oregon LNG, started Berkadia Commercial Mortgage with Berkshire Hathaway, invested heavily in a 25% stake in AmeriCredit (subprime auto lender) and a 29% stake in Jefferies during the financial crisis, and sold out Inmet and Fortescue stakes near peak of commodity market cycle.

And many more items followed recently.

Jefferies History:

Jefferies namesake, Boyd Jefferies, ran the smallish firm dealing in niche after-hours and off market equity trading for much of the 1970’s and 80’s. In 1987, Mr, Jefferies was convicted of parking stock (essentially holding accumulated stock on his company books to make it look like the real owner doesn’t yet control it) in 1987 for Ivan Boesky (the infamous corporate raider and arbitrager). Frank Baxter took over Jefferies from its namesake and in a seemingly odd choice, kept the firms name in defiance of the charges. Three years later, Baxter brought over 60 junk bond traders from Drexel Burnham Lambert (Michael Milken’s firm) after its leader was sent to prison.

This seemingly strange decision to hire a few dozen traders from a tainted firm was perhaps the ultimate vulture investment, as among those 60 folks was Richard Handler who for the next decade provided stunning profits for Jefferies arranging junk bond financing and managing trading. During the 90’s Handler rose to become the most highly compensated employee of Jefferies and at the ripe age of 38 pitched the board to make him CEO and take Jefferies in a new, broader, direction.

So in 2000, Frank Baxter stepped aside and Handler stepped into the fold to run the company and began building it from a financing and trading house into a full service investment bank by going on a research / analysis acquisition spree in the early 2000’s and then continuing a break neck pace of hiring investment bankers as wall street imploded in 2007 and 2008. From 2000 to 2012, Jefferies cut its share of revenue from principal transactions and commissions from 65% to 40% primarily by raising investment-banking revenues from just over 10% of revenue to around 30%.

During this entire process Handler was compensated handily, but ¾ of his compensation was in stock, which was never sold other than to pay taxes. Today his investment in Leucadia company stock (which converted from Jefferies stock in the merger) is worth ~$165m and he owns 2.5% of the company. I believe his alignment with minority shareholders like us is quite excellent.

The New Leucadia

In the late 2000’s, JS and IC from Leucadia began making noise about what would happen to their baby when they decided to step down. They had several options, and discussed them openly in their 2008 annual meeting. They basically said they could buy a business and bring in their management to take over control from them, they could sell Leucadia outright, or maybe they could just wind down or liquidate the company (not ideal because they had, and still have, many deferred tax assets). Shareholders were given no specific insight into which would be chosen.

As I began to do research on Jefferies in 2011, it became more apparent to me what Leucadia saw in Jefferies and Rich Handler. They had invested alongside Jefferies for more than a decade, and had owned a stake in Jefferies common stock from before the financial crisis and added to it heavily during the downturn. It also became clear to me that it was possible that perhaps one “exit” strategy for Joe and Ian could be to buy or merge with Jefferies and have an in house group that could successfully analyze, buy, and dispose of it’s various sprawling businesses.

On top of that, Handler would represent a very talented and younger executive able to bring some vitality and a strong set of skills to managing Leucadia. Starting in mid 2012, I began acquiring Jefferies stock in earnest (along with some Leucadia stock as well) as it traded right down near book value, a level at which it had essentially never traded below in the prior 20 years. By the end of 2012, Leucadia announced a deal to merge* with Jefferies and to provide a premium to shareholders. Our investment today in Leucadia carries over from this original investment more than 3 years ago.

Leucadia has had a long and successful history dealing with Jefferies:

  • Handler directly handled two bond issues of Leucadia in 1992 and 1993 right after joining Jefferies, and raised capital for Leucadia 16 more times in the coming decades
  • Leucadia also directly invested in two Jefferies hedge funds in 2000 and in 2007, both making good returns in aggregate
  • Jefferies also introduced Leucadia to Fortescue in 2006, an Australian mining firm that was a stunningly successful investment Leucadia cashed out of in 2012

I believe it’s this history that lead Leucadia to get to know, and gain respect for Rich Handler’s abilities, in addition to Jefferies superior financial performance to almost all Investment Banks during the preceding 20 years (and especially during the financial crisis).

* A fun fact, the price paid by Leucadia was the equivalent of just over 1.5x book value per share. This deal was considered not in the best interests of Jefferies shareholders (in favor of Leucadia shareholders) by a group of Jefferies investors in a lawsuit against Rich Handler, Brian Friedman, JS and IC as they were perceived as conflicted given their roles at the new Leucadia post-merger. In fact, because of this lawsuit, Jefferies shareholders received additional consideration ($0.50 / share, or about 4% of the acquisition price) two years after the merger in exchange for this perceive harm by the then board members. It’s interesting to note that the valuation implied in Jefferies today, is less than 50% of what was consider unfairly low in the merger…

As we sit here in 2015, we are three years removed from when Rich Handler (and his #2 Brian Freidman) took over Leucadia. JS continues as Chairman of the Board of Leucadia, but IC has stepped down. Roughly 50% of Leucadia is now made up of the traditional eclectic assets in various stages of maturation, some developing, some mature, many cyclical, and all for sale at the right price. The other 50% is the Jefferies business of investment banking advisory, trading, commissions, and spread income.

What’s interesting about Leucadia today is the last couple of years have been particularly mediocre from a profit perspective. Jefferies is struggling against a market environment of lower trading volume, renewed competition from other large scale investment banks recovered from the crisis, a business stinging from poorly positioned commodities exposure, and an overall management approach to risk that is more conservative than many others. Jefferies 2-3% trailing return on equity is poor to be sure, but adjusting for some reasonable items I feel are one time in nature, Jefferies looks more like a struggling business making 6-9% return on equity – still not exciting, but far from worrisome. Both Jefferies and Leucadia bonds, in the middle of a corporate debt rout, are trading slightly weak, but not particularly distressed.

Several of Leucadia’s other businesses are experiencing cyclical troughs (National Beef is losing money despite putting up >$150m in profit annually for several years recently, but the cattle herd trends look to be changing in their favor), or are in startup mode whereby they are generating much more in costs while revenues are meager or not starting yet (Leucadia Asset Management, Golden Queen, Linkem, Foresight / Chrome, Vitesse and Juneau). Leucadia also has some businesses that are doing well (Garcadia and Berkadia), but the net result is a company with a large asset value that is not on the whole earning a great return on assets or equity.

In what appears to be the focus of investors these days, Leucadia is failing:

  • It is not putting up much in the way of profits.
  • It is not growing top line revenue by a stupendous amount.

What Leucadia does have is a collection of businesses with real value, run by a team of great managers with their money on the line right alongside minority equity investors like us, selling for probably 50% less than what a rational buyer would pay in an arms length transaction for the same assets.

As an appendix to this note, I have attached estimates capturing how I think about the values of Leucadia’s various businesses. Any set of estimates is inherently flawed, and using more precision than warranted is likely only going to fool the forecaster. My valuation contemplates probabilities of the values of the assets being at or above a specified amount - low (90% likely or better) / mid (50% likely or better) / high (10% likely or better). These ranges for values of the various businesses I then sum up after netting off the liabilities of the holding company.

Conclusion

Over two decades with Handler at Jefferies, the firm basically never traded for less than book value and put up large financial returns, including outperforming all Investment Banking peers during the decade of the financial crisis; before he was CEO this performance was largely due to the portion of Jefferies that Handler was nurturing.

Since the early 1980’s, Leucadia has never traded for less than book value for any length of time. Now today, as we sit in December of 2015, the market thinks that Leucadia National today, which is just a combination of Jefferies and old Leucadia, with Rich Handler and JS still directly involved, is worth less than 60% of book value. Even if you strip out all the goodwill and intangibles from the balance sheet (related to Jefferies and National Beef acquisitions), the price is still about about 25% below tangible book value.

The reasons for this seems simple, if not terribly rational:

1) The market liked the JS and IC show, but not so much the Rich, Brian and JS show.

2) The market has suddenly decided that Jefferies is a very bad business

3) The market believes that Rich Handler has somehow managed to make all the legacy purchases made before his arrival worth much less than before

4) The market believes that Rich and JS and crew got a sudden case of stupid

5) Tax loss selling is the tail wagging the stock price dog

6) … or perhaps, it’s a bit of 1-5

There is of course an alternative reason for this valuation (and of course it could always be a blend); the market is myopically focusing on earnings when it should be looking the raw intrinsic asset value of a business. I believe the market is punishing Leucadia shareholders because the firms business lines are generally much more positively correlated to inflation* than the average firm, and inflation has been nowhere to be found lately. Inflation investment themes are so far out of favor as to be missing in action. I also believe many shareholders who normally would be buyers or holders of Leucadia through any rough patch have been given a convenient and irrational excuse to sell; new management which isn’t the same the old management.

* From 2012 annual meeting (and other times as well) – Joe Steinberg - "The portfolio of companies at Leucadia is a bet on inflation... If you don't agree with that outlook, you should sell your shares."
I must confess to being far too bullish on the business results of Jefferies specifically and some of Leucadia’s other businesses recently. However, I do not believe the recent poor earnings performance at Leucadia is symptomatic of a management team that has lost its way, or a business whose asset values have been compromised. I view the results as the normal cyclicality and randomness that comes with running a real business and reporting results using real, as opposed to managed, accounting.

I am as confident in Rich Handler and JS as I have been when I first invested with Jefferies, and I am excited that the same market which has been rewarding many firms with questionable business values, models, and ethics with extremely high price to earnings, and price to book ratios is giving me a chance to buy one of my all time favorite firms at a throw-away-and-left-for-dead price. My central case valuation estimates Leucadia shares to trading at about 50% of their fair value. Buying firms this cheaply, with excellent management is the surest way to make money, and avoid losing it I am aware of.

Before the fun valuation table at the end, I will leave the reader with a quote, which while old, I believe still captures the essence of Leucadia. While their investment styles and strategies will evolve and be shaped more by Rich Handler going forward, this quote is still what this company is about.

“We tend to be buyers of companies that are troubled or out of favor and as a result are selling substantially below the values which we believe are there. We then work at improving the acquired operations with a view to increasing cash flow and profitability. From time to time we sell parts of these operations when prices available in the market reach what we believe to be advantageous levels. While we are not perfect in executing this strategy, we are proud of our long-term track record. We are not income statement driven and do not run your Company with an undue emphasis on either quarterly or annual earnings. We believe that we are conservative in our accounting practices and policies and that our balance sheet is conservatively stated.” - Leucadia 1990 Letter

Leucadia is my personal, and Remick Capital client’s, largest investment by far and I would echo much of the above sentiment for myself personally and professionally. If you buy out of favor assets at a discount to probable value, soundly financed, that are then managed well, you will have the opportunity to earn above average returns both from the enhanced income achieved from buying lower, but also from the potential optionality that comes with the ability to perhaps, one day, to sell high as well. In the interim, you can earn good tax adjusted returns. I hope we are able to hold our investment in Leucadia and let it compound for many years.

Leucadia is the stock I like best.

Leucadia