Can Jefferies Repeat Bond Performance in 2013?

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Jefferies Group (NYSE: JEF) posted better than expected results for its fiscal fourth quarter, which saw profits jump by 48% from last year to $71.6 million. Revenues increased by 37% to $760.6 million, which is about $38 million more than analysts’ expectations. It should be noted that Q4-2011, from which the current results are being compared, was particularly tough for Jefferies; its income, excluding extraordinary items, dropped by 38% from 2010 to $39 million. Although the current year-over-year increase in profits is 48%, sequentially they are up a more modest 2.04%. 

In this quarter, Jefferies investment in Knight Capital (NYSE: KCG) contributed $48.7 million to revenues, which has had a tumultuous year to say the least. Currently, Jefferies is the largest shareholder in Knight Capital. The bank’s investment – more like a life preserver – in the brokerage firm has paid off as Knight’s shares have been up 15% since Aug. 7 on short-covering and lack of bad news.

Jefferies traditionally starts the earnings season for investment banks. These results were driven by its fixed income unit; U.S. Treasuries were strong all year and this bodes well for cash flow from other Primary Dealers, such as Morgan Stanley (NYSE: MS) or JPMorgan Chase (NYSE: JPM) .Their earnings releases are due by mid-January.

The global economic slowdown and the high levels of uncertainty, particularly regarding the fiscal cliff, have made the various U.S. bond markets more attractive to investors all year.  The run in treasuries was so strong and yields pushed so low that there was significant spillover into both the corporate bond market (the iShares iBoxx $ Investment Grade Corporate Bond ETF saw nearly $5 billion in net inflows this year) and dividend stocks when corporate bond prices were pushed higher as well.

This will be the last earnings report by Jefferies as an independent firm, as it is being taken over by Leucadia National Corp (NYSE: LUK), its biggest shareholder, which already owns 28% of the firm, for $2.76 billion. Starting next year, the bank will start a new life under Leucadia.

In calendar year 2011, Jefferies’ stock tumbled by 48.4%, as until the very end it wasn’t clear whether the firm would survive the debt crisis or would follow MF Global. In 2012, however, the shares have been up an impressive 36.2%. The current merger is good news for Jefferies since it will have the backing of a powerful investor, something smaller firms are seeking in the uncertain economic environment. Leucadia already has $1.4 billion in deferred taxes. The merger with Jefferies is going to decrease its tax rate, which will save the firm several millions. 

<table> <tbody> <tr> <td> <p><em> </em></p> </td> <td> <p><em>JEF</em></p> </td> <td> <p><em>MS</em></p> </td> <td> <p><em>GS</em></p> </td> <td> <p><em>JPM</em></p> </td> </tr> <tr> <td> <p>Stock YTD</p> </td> <td> <p>36.2%</p> </td> <td> <p>25.0%</p> </td> <td> <p>42.0%</p> </td> <td> <p>32.3%</p> </td> </tr> <tr> <td> <p>P/E</p> </td> <td> <p>15.35</p> </td> <td> <p>N/A</p> </td> <td> <p>12.33</p> </td> <td> <p>9.34</p> </td> </tr> <tr> <td> <p>EPS</p> </td> <td> <p>1.22</p> </td> <td> <p>-0.46</p> </td> <td> <p>10.42</p> </td> <td> <p>4.71</p> </td> </tr> <tr> <td> <p>Yield</p> </td> <td> <p>1.60%</p> </td> <td> <p>1.00%</p> </td> <td> <p>1.50%</p> </td> <td> <p>2.7%</p> </td> </tr> <tr> <td> <p>ROA</p> </td> <td> <p>N/A</p> </td> <td> <p>-0.03%</p> </td> <td> <p>0.59%</p> </td> <td> <p>0.84%</p> </td> </tr> <tr> <td> <p>ROE</p> </td> <td> <p>8.9%</p> </td> <td> <p>-0.35%</p> </td> <td> <p>7.6%</p> </td> <td> <p>10.1%</p> </td> </tr> </tbody> </table>

The bank’s management has been lauded in the past due to its efforts in the Euro Zone debt crisis. Like its old rival MF Global, Jefferies also was heavily exposed to Europe, and it was feared that the bank would be the next one to go under after MF Global’s collapse. But an in-depth analysis of Jefferies’ books by the U.S Commodity Futures Trading Commission last year revealed that the bank’s risk management strategy was much better than that of MF Global’s, and their status as a Primary Dealer made them closer to the bailout mechanisms.   

The Federal Reserve’s decision to purchase $40 billion in mortgage-backed securities has multiplied trading activity, which is exactly the Fed’s plan: to generate higher money flow.  Jefferies’ trading revenue increased by 107% from the same quarter last year to $293 million, while investment banking revenues are up 8% to $283 million. The total trading revenue has increased by 64% to $469.6 million. 

The U.S. Treasury bond buying will not abate in 2013: QE III and QE IV are both designed to soak up new supply of long-dated Treasuries to finance 2013’s budget deficit as the appetite from foreign lenders is slowing down.  This will turn primary dealers like Jefferies/Leucadia into greater extensions of the Fed’s balance sheet as financial repression really begins in earnest in 2013.

At this point it’s unclear whether Treasury bond yields can push much higher with the current fundamentals and array of sellers that exists outside U.S. borders.  I wouldn’t bet on a bond collapse in 2013, but I wouldn’t bet on another massive run like we had in 2012 either.  In relative terms, Europe is more fixed than the U.S. and, because of that, there won’t be another massive bout of capital flight out of Europe and into the dollar like we saw in 2012.  Therefore we can expect to see more muted gains from bond trading and lower profits from the fixed income divisions of these investment banks, as they can’t be net sellers of Treasuries due to their being Primary Dealers and bound, by law, to buy all issuances.  

PeterPham8 has no positions in the stocks mentioned above. The Motley Fool owns shares of JPMorgan Chase & Co. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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