Reggie Middleton's Boom Bust Blog

I've started to look into the Jefferies Group Inc., and thought I would share some preliminary findings.

Increased dependence on short term financing (higher REPOs)

Repurchase agreements are classified as a money-market instrument and used as a key source of short term capital by investment banks. Investment banks have been dependent on repo financing for their capital structure needs for quite sometime now. Jefferies is heavily dependent on repo financing with 40% of its liabilities account for repurchase agreement as compared to 13% last year. It is significantly higher when compared with to other bigger names in the investment banking industry such as Lehman Brothers at 27% and Goldman Sachs at 15%. In the last four quarters, the company’s securities sold under agreement to repurchase has increased to US$11 billion at the end of 2007, from US$2 billion at the end of 2006.

Difficult operating environment and rise in compensation ratio drives 4Q 07 losses- Jefferies Group reported a net loss of US$23.5 million in 4Q 07 owing to challenging credit market conditions and a rise in compensation and non compensation ratios. Jefferies reported high compensation ratio largely due to increase in the headcount in line with the company’s growth strategy. The compensation ratio increased to 60.3% for 2007 as compared to 54.3% for 2006 with the average employee headcount increasing 12% to reach 2,394 in 2007. Jefferies also paid higher signing and guaranteed bonus which exerted pressure on the margins.

Non compensation ratio also increased to 24.0% of net revenues in FY 2007 compared to 21.8% in FY 2006. The increase in non-personnel expenses is attributable to increased compliance, technology and communications costs. In addition, the new hiring has resulted in increased occupancy at London and New York offices

Fixed income revenues under severe pressure in the last two quarters

Fixed income, and commodities revenue comprising high yield secondary market trading activities, investment grade fixed income, and commodities products revenue also declined during the quarter. Fixed income's contribution to revenues has declined to 6% in 2007 from 12% in 2006. The revenues declined 29% to US$173.1 million owing to extremely challenging and illiquid US high yield credit markets in the second half of 2007. The widening spreads and reduced levels of liquidity negatively impacted the high yield products and resulted in a significant decline in revenues from fixed income products in 3Q 07. However, the contributions from the investment grade fixed income products and volatility in commodities product in 4Q 07 supported the revenue growth. As the abating of credit crisis still not in sight after the number of steps taken by US Federal Reserve, revenues from these operations will be under pressure.

Investment banking revenues declined sequentially

The investment banking operations contributing 28% of the company’s total revenues has declined 12% on a sequential basis to US$167 million. The decline is attributable to the challenging market environment as the ongoing credit crisis has restricted the growth of the sector. The investment banking activities in the near future is anticipated to remain subdued owing to difficult market conditions and tight liquidity conditions.

Jefferies Group’s investment banking activities are focused on sectors not considered volatile like the aerospace and defense, energy, gaming and leisure, healthcare, industrial, retail & consumer, technology, oil service & infrastructure, media and communications. The company also provides investment banking services to some financial services companies. The exposure to varied sectors has helped Jefferies in reporting healthy revenues from investment banking operations in the difficult market environment.

Deteriorating fixed charge coverage ratio raises questions on company’s ability to service loans

The company’s fixed charge coverage ratio has declined from 5.5X in 2005 to 3.0x in 2007 owing to increased debt issuance. The company’s long term debt has increased from US$780 million in 2005 to US$1.9 billion in 2007 increasing pressure on its ability to service the loans.