Leucadia National, Corp.
Ticker Symbol: LUK
Website:
http://www.leucadia.com/
Sector: Conglomerates
Industry: Conglomerates
Market Capitalization: $6.27 billion
Enterprise Value: $5.41 billion
Average daily trading: 960 thousand shares // $29.3 million
Shares outstanding: 216.19 million
Float: 143.40 million
52-week stock price range:
$18.90 - $32.62
Current price: 28.74
Fair valuation estimate: 35.89
Profile
Leucadia operates in a variety of businesses including primarily manufacturing, healthcare, telecommunications, real estate, winery operations.
Strategy
Business Plans
Leucadia National intends to continue what it has been doing: Operate its current assets, seek to acquire undervalued or troubled assets, improve the value of owned assets, and create favorable cash flow realizations.
Economic Moats
None of Leucadia’s segments enjoy significant economic moats. The company relies on superior management skill in generating returns.
Management Structure:
Ian M. Cumming
Chairman of the Board of Directors, Chairman of the Executive Committee, Chief Executive Officer
Joseph Steinberg
Director, Member of the Executive Committee, Chief Operating Officer, President
Ian M. Cumming and Joseph Steinberg are the two key figures at Leucadia. They are supported by a relatively large number of exemplary senior managers. The continuing success of the company depends on these managers as well as the CEO and the President. In their 2005 letter to shareholders, Ian M. Cumming and Joseph Steinberg wrote:
[We] get most of the credit for what goes on in Leucadia but we should not–just some of it. We have a large group of dedicated hard working people who do most of the work and it is they who should get most of the credit. We are the orchestra conductors–we don’t play a note but we stand in front of everybody and wave a stick.
Ian M. Cumming and Joseph Steinberg oversee a broad team of mangers whom they make responsible for specific projects. So far they have done an exemplary job:
Return on equity has averaged greater than 20% per year since 1979
Return on the common stock has averaged greater than 25% per year since 1979
Both Ian M. Cumming and Joseph Steinberg have nine years remaining on their contracts with Leucadia.
We view management as being exceptionally straightforward, forthcoming, and honest in their letters to shareholders and in the company’s SEC filings; we view this as a substantial positive. As we wrote recently, management’s ethics and sense of fairness to shareholders may play a large role in value creation. A couple examples from their 2004 letter demonstrate these management qualities:
One of us is skeptical that WilTel will ever be a successful investment; the other continues to believe that there will be future riches on the wings of broadband!
We plan to continue to search for undervalued or out-of-favor assets that we can buy and improve. The pickings are slim, but our enthusiasm is unabated. If we run out of ideas or steam we will let you know and develop a plan to return money to our shareholders.
(Leucadia divested of most of the WilTel assets in 2005 for a profit.)
Corporate Governance
Institutional Shareholder Services rates Leucadia’s corporate governance as better than 43.9% of companies in the S&P 400, and as better than 79.6% of diversified financial companies.
Key positives of the current corporate governance structure:
The entire board of directors is elected annually
This makes takeovers possible in a timely manner, and forces managers to act responsibly
There is not a dual class shareholder structure
Company manager’s do not hold a disproportionate share of the voting rights – it is based on ownership
Simple majority votes are sufficient for the approval of a merger or change in the charter or bylaws
There is no poison pill in place
Poison pills are often used by managers who want to protect their jobs (and not for shareholder benefits)
75% of the members of the board of directors are independent
Board member independence helps ensure that shareholders are fairly represented
The entire audit committee is independent
The entire compensating committee is independent
The entire nominating committee is independent
Key negatives of the current corporate governance structure:
The CEO is also the Chairman of the board of directors
This is often a negative as it suggests that one officer has too much power to influence the company – this may result in unfair practices or overconfidence-induced mistakes.
We believe that Leucadia’s corporate governance structure is quite good for shareholders. Given the company’s history of tremendous success, Ian M. Cumming’s apparent honesty, and the existence of a President, we are comfortable with the combination of CEO and Chairman; the substantial institutional ownership of the stock (57.5%) and the reasonable size of the top ten institutional holdings (33.8%) also act to ensure Ian M. Cumming is acting in the best interests of shareholders.
Risks
Market Risk
We used data from July 6th, 1999 until July 3rd, 2006 to calculate the âeta against the S&P 500; we find it to equal 0.598. This value is robust to the elimination of outliers.
Industry Risks
Since Leucadia operates in a variety of industries, it is less subject to industry-specific risks than most other companies. However, Leucadia’s profitability is still subject to industry changes, especially in areas where it has relatively large operations – manufacturing, healthcare, telecommunications, real estate, and winery operations.
Firm Specific Risks
Leucadia benefits greatly from its strong management team. The loss of a senior manager would likely reduce our long-term earnings outlook. Although Ian M. Cumming and Joseph Steinberg report that they are in good health, they are both in their 60s.
The interest coverage ratio is high in comparison to historic averages. In consideration of the company’s relatively stable pretax earnings, this suggests good financial health. The total debt to equity and long-term debt to equity ratios are also low in comparison to their historic values; this is also suggestive of relatively good financial health. At the year end of FY 2005, the company had $387 million in cash and cash equivalents ($419 million at the end of Q1 2006).
Financial Statement Analysis
When first beginning to investigate Leucadia, we were confused why this liquid multibillion dollar company did not have any analyst coverage. We quickly figured it out. It is lots of work! Leucadia carries many items on its balance sheet at prices that may differ substantially from market rates, and the fair values of which are difficult to determine. It is also difficult and time-consuming to perform comprehensive analyses of all the components of Leucadia’s business. We have only done a partial, (although we believe relatively robust) analysis of Leucadia’s operations and financials.
Mark to Market Adjustments
Balance sheet
We mark to market the pension plan, make adjustments for off-balance-sheet financing (operating leases), eliminate goodwill, reduce the deferred tax asset to represent present rather than cash value, and mark-to-market shares held at cost for which there is a reliable price. We do not have reliable data for the values of other assets, so we do not mark them to market. However, based on the company’s historic realizations (and positive historic inflation and increasing real-estate prices), we would estimate that we are understating shareholder’s equity.
Asset adjustments (millions):
Deferred Tax Asset
$ (136.70)
Off-Balance Sheet Assets
$ 38.51
Off-Balance Sheet Guarantee
$ 85.10
Mark-to-Market of Investment
$ 64.10
Liability adjustments (millions):
Off-Balance Sheet Financing
$ 38.51
Off-Balance Sheet Guarantee
$ 85.10
Unrecognized Pension Expense
$ 40.74
The net results of our adjustments (millions):
Reported
Adjusted
Assets
$5,260.90
$5,311.91
Liabilities
$1,599.00
$1,763.35
Shareholder's Equity
$3,661.90
$3,548.56
Our balance sheet adjustments reduce the book value of the company by 3.1%.
Income
Adjusting earnings for stock option expense reduces earnings by an average of 0.54% during the past three years.
Earnings Quality
FY2005 earnings should not be interpreted as being representative, since they include nonrecurring events. However, earnings appear to be of high quality in that they do not exaggerate the profitability of the firm; we found no earnings quality warning signs. Earnings may be somewhat understated due to the use of exaggerated depreciation expense; free cash flows have been consistently higher than pretax income less normal corporate taxes (by a factor of three over the past five years, on average).
Free Cash Flow and Income (millions):
Free Cash Flow
$298.50
$85.10
$191.30
$111.90
$20.70
Pretax Income * (1 - Tax Rate)
$60.45
$85.67
$27.82
$8.58
$34.91
Recent Growth
After adjusting for divestitures, revenues and earnings have risen drastically over the past year. Revenues for Q1 2006 were $386.5 million; revenues for Q1 2005 were $121.3 million. Income from continuing operations (before income taxes and equity income from associated companies) for Q1 2006 was $109.9 million; income for Q1 2005 was -$17.2 million.
The strong recent revenue and earnings growth is a positive sign that the managers at LUK are continuing to create value.
Profitability
A large portion of Leucadia’s profits arise as a result of value-enhancement activities, rather than profits from continuing operations. The company’s operations also changed substantially in 2005, due to the sale of WilTel assets. Hence, we believe that traditional profitability metrics do not provide much value in our analysis. However, we have nevertheless included the basic profitability measures.
Using unadjusted income statement and balance sheet data:
Fiscal Year
2005
2004
2003
Gross Margin
46.99%
59.03%
68.03%
Operating Margin
19.84%
27.37%
9.46%
Return on Assets
31.10%
3.03%
2.21%
Return on Common Equity
44.68%
6.44%
4.55%
If you are looking at the above and thinking that it looks strange, you’re right. The ROA and ROE values include the effects of taxes (negative every year for the past five years) and the effects of discontinued operations.
The high gross and operating margins are a good sign of financial health.
Transaction Analysis
Acquisitions and Divestitures
Leucadia continues to provide value to shareholders through the acquisition of undervalued assets, value-enhancement activities, and the divestitures. Although the availability of appropriate and undervalued assets changes over time, Ian M. Cumming and Joseph Steinberg currently believe that there are several opportunities; in their 2005 shareholder letter they wrote:
We have many things in the hopper that look interesting and hopefully by next year at this time we will have a measurable reduction in cash and an increase in higher yielding investments.
This was in stark contrast to 2004’s letter, where they expressed concern over a lack of investment opportunities (Leucadia’s cash holdings increased by $110 million in 2005):
We plan to continue to search for undervalued or out-of-favor assets that we can buy and improve. The pickings are slim, but our enthusiasm is unabated. If we run out of ideas or steam we will let you know and develop a plan to return money to our shareholders.
We view the positive outlook for investment opportunities as a favorable signal of future return on equity.
The recent profitable divestiture of some WilTel assets is also a reassuring sign that the managers at Leucadia are continuing to produce value, especially since WilTel was from the troubled telecom industry.
Insider Transactions
Insider selling has been modest; net, 9,808 shares were sold over the past twelve months; 21,650 shares were bought, and 31,458 shares were sold.
Officer Hubert Eugene Scruggs Jr. sold 21,108 shares; his remaining stake is 25,392 shares.
Officer and Treasurer Thomas E. Mara sold 4,350 shares; he has 33,150 shares remaining in his portfolio.
Chairman and CEO Ian M. Cumming bought 200 shares; he now owns more than 12 million shares.
Director Jesse Clyde Nichols III sold 6,000 shares and then bought 6,450 shares; he now owns 103,520 shares.
Director Jeffrey C. Keil bought 5,000 shares; he now owns 5,000 shares.
The average purchase price for the insider transactions was $25.28/share (split adjusted); the average sale price was $23.24/share.
Although insider transactions were net sales, we view the transactions in a neutral light from a signaling perspective; insider transactions are usually sales.
Institutional Transactions
Institutional transactions have been essentially flat; institutions bought 10.3 million shares and sold 10.8 million shares.
From a signaling perspective, we view the institutional transactions as neutral.
Valuation
Relative Valuation
Leucadia’s price-to-book ratio of 1.65 is low in comparison to the industry average of 3.02, and also to the S&P 500 average of 2.75. In consideration of management’s proven ability to generate high long-term return on equity, we believe that this discount is unjustified.
LUK appears attractively priced from a relative value perspective.
Fair Value
We use the conservative mark-to-market adjustments outlined above and the effects of stock option dilution to adjust the reported book value. Our adjusted estimate of the fair value of net assets is $15.86/share.
The geometric average growth in book value per share has been roughly 14.5% over the past twenty years; this value has been relatively consistent across different time horizons.
Historic ROE has been high and relatively consistent over long periods of time:
Average ROE
Geometric Average Growth in Equity
5-year
15.68%
14.28%
10-year
15.46%
13.75%
15-year
17.47%
14.45%
20-year
17.61%
14.48%
25-year
22.97%
19.98%
We forecast that ROE will be a constant 14.3% for the next nine years (the duration of the contracts for Ian M. Cumming and Joseph Steinberg). Subsequently, we assume that ROE will decline by 1/3 of the difference between the current ROE and the steady-state ROE. We have set the steady-state ROE equal to the required return on equity.
For the fair return (and discount rate), we use an equity risk premium of 3% over bonds, our calculated beta1 of 0.598, and the current bond rate of 5.1%; the discount rate we use is 6.89%.
We apply the Edwards-Bell-Ohlson (residual income) model to our adjusted book value of $15.86/share and our ROE projections.
We estimate the fair value of LUK to be $35.89. The fair value estimate’s position above the current stock price of $28.74 is relatively robust to changes in our assumptions.
All else held constant, V0 (fair value) > S0 (current stock price) if:
Beta
<
1.32
Equity Risk Premium
<
6.60%
9-year ROE
>
12.74%
Growth Reduction Fraction
<
100.00%
From an absolute valuation basis, the stock appears attractively priced at current levels.
Revaluation Catalysts
Although some catalysts may act to create minor short-term gains, no revaluation catalysts are likely to drive LUK to its fair value in the near-term. We believe the most likely catalyst for a revaluation is an improved corporate profile; this may be caused by:
Increased analyst coverage
Leucadia participating in high profile transactions
Increased media attention related to Warren Buffet and Berkshire Hathaway
Conclusion
We believe LUK is undervalued. Our estimate of fair value
is $35.89.
Stock price revaluation to our fair value target is likely to take a long time; there are no substantial catalysts for revaluation.
Short-term upside is likely to be driven by increased corporate exposure to investors. Long-term upside will be driven by deal flow and value improvements to existing assets.
TECHNICALLY = NEUTRAL
Enviado: 16/9/2006 11:02
A breakout would be bullish. 