Jefferies Financial Group Inc. quarterly report, Q2 FY2011

Business context and reporting period

Filing identity: The supplied filing is Leucadia National Corporation’s Form 10-Q for the quarter ended June 30, 2011—not a filing under the name Jefferies Financial Group Inc. Leucadia reported its roughly 27% investment in Jefferies as an associated-company investment.

Leucadia is a diversified holding company with operating businesses in manufacturing, oil and gas drilling services, gaming, real estate, medical product development and other activities, alongside a substantial investment portfolio. Results below compare the three and six months ended June 30, 2011 with the corresponding 2010 periods. Dollar amounts are in millions unless noted.

Financial performance and position

• Earnings drivers: Q2 included a $527.4 million gain from selling part of the Fortescue investment. Six-month results also included an $81.8 million gain on forgiveness of Myrtle Beach project debt. These items substantially affect comparisons and are not recurring operating results.
• Associated companies: Pre-tax losses from associated companies were $225.9 million in Q2 and $270.1 million for the first half, mainly reflecting fair-value losses on Jefferies. The six-month Jefferies-related loss was $319.5 million.
• Operating businesses: First-half revenue and pre-tax results improved at drilling services and gaming, while manufacturing remained pressured. Domestic real estate’s first-half profit primarily reflected the Myrtle Beach debt-forgiveness gain. Sangart, the medical product development business, reported a $13.4 million first-half pre-tax loss.
• Margins: The filing does not provide a consolidated operating-margin measure. Segment performance varied; Idaho Timber’s spread fell 19% for the first half, while higher polypropylene resin costs pressured Conwed Plastics.
• Cash flow: First-half operating cash flow was $1.9 million, versus $57.6 million used in the prior-year period. Investing activities used $22.5 million; financing activities provided $118.3 million. Cash increased $97.8 million to $539.1 million.
• Balance sheet and liquidity: At June 30, total assets were $9.19 billion, total liabilities $2.39 billion and total equity $6.81 billion. Current assets were $1.49 billion and current liabilities $826.4 million. The company reported $1.47 billion of long-term debt, $659.5 million of repurchase agreements and $1.0 million of debt due within one year. Its stated available liquidity was $3.72 billion, after excluding $960.6 million of investments that were pledged, restricted, non-public or otherwise unavailable for general use.

Material changes versus the prior comparable period

• Net income shifted from a substantial loss to a profit in both the quarter and first half, driven principally by realized securities gains, especially the Fortescue sale, and the Myrtle Beach debt-forgiveness gain.
• Leucadia sold 92.4 million Fortescue shares in June for net proceeds of $609.2 million. Its remaining holding was 155.6 million shares, about 5% of Fortescue; the investment’s reported fair value fell from $1.66 billion at year-end to $1.06 billion at June 30, with the change also reflecting shares sold.
• Jefferies’ market-value decline generated a $327.3 million unrealized loss for the first half. Leucadia also bought 5.15 million Jefferies shares for $125 million in April; its reported ownership was approximately 27% at June 30.
• Investments in associated companies declined to $1.83 billion from $2.27 billion at year-end, including repayment by Berkadia of its secured facility and Leucadia’s $250 million loan.
• Leucadia acquired Seghesio Family Vineyards in June for $86.2 million and invested an additional $50 million in Sangart. It also repurchased specified debt securities during the first half and recorded $6.4 million of related pre-tax losses.
• First-half accumulated other comprehensive income fell to $1.31 billion from $1.69 billion, principally reflecting a $374.7 million after-tax decrease in unrealized investment gains.

Outlook, commentary, risks and unusual items

• No numerical consolidated earnings or revenue guidance is provided. Management cautioned that interim results are not necessarily indicative of full-year results and that security gains and real estate results can be unpredictable.
• Management said weak economic conditions, housing-market softness and reduced consumer demand could continue to affect operating businesses. Idaho Timber expected housing weakness to weigh on revenue; Conwed cited competitive pressure and rising raw-material costs. Drilling results remain exposed to commodity prices, rig supply and activity levels.
• The Fortescue note entitles Leucadia to interest based on iron-ore project revenue. Fortescue disputes whether it can issue additional similar notes that could dilute Leucadia’s interest. Litigation was pending; an adverse outcome could materially reduce future cash flows and might require an impairment assessment. Leucadia received $98.8 million in August 2011 for accrued interest through June 30, net of withholding tax.
• Leucadia reported a $1.26 billion net deferred tax asset. Realizing it depends on future taxable income and investment dispositions; management estimated approximately $4.0 billion of future U.S. pre-tax income would be needed to realize it fully. Further valuation-allowance adjustments remain possible.
• Sangart began a larger Phase II clinical study in trauma patients. Further Phase II and potential Phase III studies would take years and require substantial spending; the filing says profitability and eventual product revenues cannot be predicted.
• Other notable items include $14.5 million of first-half share-based compensation, primarily related to new senior-executive warrants; a $9.0 million settlement of Premier noteholder litigation, which reduced a previously recorded liability by $2.2 million; and ongoing New York State and City tax audits for 2006–2008.
• Management stated that current litigation was not expected to materially adversely affect consolidated financial position, results or liquidity, but acknowledged that amounts paid above reserves could be significant to a period’s results. The reported contingent-loss accrual was not significant.

Important facts for investors to verify

1. Confirm the issuer: the provided 10-Q is for Leucadia National Corporation, despite the request metadata naming Jefferies Financial Group Inc.
2. Separate recurring operating performance from the Fortescue securities gain and Myrtle Beach debt-forgiveness gain when assessing earnings quality.
3. Review Jefferies’ subsequent share price and Leucadia’s resulting investment exposure, given the $319.5 million first-half Jefferies-related loss.
4. Track the Fortescue note litigation, future interest receipts and any potential dilution of the contractual revenue interest.
5. Assess the liquidity and valuation sensitivity of the investment portfolio, including the securities counted in available liquidity and those excluded as restricted or otherwise unavailable.
6. Evaluate the assumptions supporting realization of the deferred tax asset, including the need for approximately $4.0 billion of future U.S. pre-tax income.