Jefferies: Growing to Fill the Void of Lehman and Bear?

Jefferies Group (JEF), an independent, full-service global securities and investment banking firm, is surging higher by nearly 8% on Tuesday afternoon following reports of a much better than expected second quarter result.  Earnings spiked 37% in the quarter to $85 million or 41 cents per share, well ahead of analysts’ estimates of 36 cents per share.  Revenue also easily exceeded expectations of $548 million as it topped $670 million in the quarter ended May 31.  The quarter’s success was aided by a 112% jump in their investment banking division’s revenue.  Other divisions paled in comparison to the success of investment banking, as trading commissions rose slightly and principal transactions actually declined 38% from the three month period a year ago (ended June 30, 2009).  Additionally, they have grown their asset management business from a tiny unit a year ago, to bringing in a not insignificant $13.93 million in revenue in the quarter.

Increased business advising on capital markets activities and M&A transactions was key to the company’s success in the quarter, and may be a have further growth potential through the rest of the year.  The company has taken advantage of the turmoil in the financial sector over the last two years, as they were able to pick up talented employees cast of from shrinking of failing financial firms.  For example, Jefferies hired nearly the entire team of health-care bankers (more than 30 people) from UBS (UBS) a year ago; a move that the Wall Street Journal claims has allowed it to become joint adviser and finance provider on a $3.8 billion acquisition in the sector.  Furthermore, Barron’s describes this phenomenon at work in other business segments,

“Evidence of the company’s confidence has been its spate of expansions of late. In just the last month, it has expanded its municipal bond trading, Asian emerging markets and global equity sales teams, as well as its international credit trading platform.

In sum, Jefferies has a history of outperformance, and its latest quarterly results show it has been making the best of the current environment and embracing the glut of talent available.” – Barron’s Online 6/22/2010

It is this kind of growth that has allowed Jefferies to do more in less time.  In fact, the company has changed its fiscal year end from December to November, yet it has actually expanded revenue 7% in the five month period compared to the six-month period a year ago.  Profit has grown even more substantially, increasing more than 18% over the same time frame.  Some analysts are fussing about the fact that the company’s book value declining by 15 cents to $13.33 at quarter end, but we are not so concerned.  We believe the company is clearly growing and expanding its reach to fill the void left by Bear Stearns, Lehman Brothers, et al.  Thus far, it has been one of the primary beneficiaries of the new competitive landscape, and that gives us confidence in management’s ability to navigate this ever-evolving environment.

At Ockham, we currently have a Fairly Valued or neutral rating on JEF, as it traded within its historically normal range of price-to-sales and price-to-cash earnings as of our report to start the week.  However, we may consider an upgrade in the coming weeks—assuming the price does not advance too much—because the second quarter’s results were stronger than we anticipated.  Jefferies has clearly seized an opportunity to become bigger and stronger than it had been, and we could reasonably see the stock trading for $30 before the end of the year.

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