Jefferies Financial Group Inc (NYSE:JEF) operates in the investment banking, capital markets, and asset management sectors across the Americas, Europe, the Middle East, and Asia. It consists of two main business segments: Investment Banking and Capital Markets, and Asset Management. Investment banking services include Mergers and acquisitions, restructuring and private capital transactions, underwriting for equity and debt, and corporate lending.
Jefferies is a highly regarded investment bank and is generally considered a tier below the traditional “bulge bracket” banks, those being the most elite investment banks globally. This has allowed the company to grow quickly in recent years, as the post-COVID boom in transactions has fuelled growth beyond what the few tier 1 players can accommodate.
This has translated into an impressive rise in JEF stock price, dwarfing what looked to be over half a decade of stagnation. The recent jump has been driven by Sumitomo Mitsui taking a large stake in the business, which could involve future transactions building their position to 20-50%.
The main question is whether the strong performance in recent years will persist going forward, or if we will see a sharp correction. Our analysis will examine the overall quality of Jefferies and the current state of the investment banking industry. We will also compare Jefferies with other similar-sized investment banks to determine if they are performing well and if its share price today is undervalued on a relative basis.
Economic conditions will contribute to softening market conditions
We are currently experiencing significant pressure on demand, as inflation remains persistent and rates are elevated. Central banks have been raising rates to cool demand. This has been working but is slow in effectiveness. This has contributed to a cost-of-living crisis for many individuals as they face rising prices and borrowing costs, compounding their problems. Many businesses have also struggled, as a major contributing factor to inflation has been supply-side disruptions and rising energy costs.
The situation is further complicated by geopolitical events and trade tensions. For example, China and the US are currently battling out the future of the semiconductor industry. This has the potential to impact capital markets should legislation be used.
In 2023, we expect more of the same, as inflation is remaining persistent. As the above graph shows, inflation has only marginally dipped in the most recent month. The FED will likely need to raise interest rates further or face losing inflation’s downward momentum. If they don’t, they will have to keep them at a higher level for a longer period. This could potentially lead to a recession, which would further decrease demand and damage the economy. The inversion of the 10Y/3M yield curve increases the chance of this.
This will have a negative impact on capital markets. There are several reasons for this, firstly lower demand and rising costs contribute to weakening companies, which make them less attractive and less able to conduct M&A.
The second reason, however, in our view is the most significant. Having spoken to many clients in recent months, the biggest issue for them is the current cost of capital. With heightened borrowing rates, the delta in valuation between the buy-side and sell-side has increased to a level where both sides have decided to leave the table. The sell-side would prefer to further build their business for another 12-24 months, while the buy-side look to further optimize their current business / portfolio of businesses. Our view is that the industry can only pick up once the cost of borrowing falls, as the difference in valuations is far too high to converge naturally.
Current forecasts do not look good, with the US Fed Funds Rate projected to trend around 4.25% in 2024 and 3.25% in 2025, according to Trading Economics.
The investment banking industry is highly cyclical, usually following in line with the global economic lifecycle. Having identified that we are in for a tough 2023, the question is how robust the IB industry will be.
PwC found that the transaction volume is decreasing rapidly, with a drop below the levels of 2021. The main cause behind this is the economic climate, which is generating a sense of insecurity among many. In EMEA, the volume and value of transactions declined by 12% and 37% respectively, with the Americas following at 17% and 40%. PwC specifically pointed out the TMT sector as one that may remain strong, with 25% of the total deal volume and value in 2022 being attributed to this sector. Dealogic’s data for Q1-23 seems to support these findings, with evidence of a major decline in transactions in recent weeks.
Examining Jefferies more closely, the bank appears to have had a sluggish beginning to the year. In 2022, it was ranked 8th in total investment banking revenue, but it has not made it into the top 10 so far this year. Although it’s still early, any further economic decline could pose challenges in completing transactions.
PwC’s outlook suggests things could pick up in the second half of the year, as market participants better understand current conditions and valuations normalize. Deloitte concurs with this view, believing that total volume / value will be about 15% below that of 2021, but importantly not a repeat of 2008/09.
This could pose a challenge for Jefferies as the majority of its fiscal year 2022 revenue, 48%, was generated from underwriting and investment banking fees. With the business being significantly dependent on this segment of the market, it may result in fluctuation in its quarterly income that mirrors the ups and downs of the deals market on a quarter-by-quarter basis.
Over the past 5 years, Jefferies has experienced a 12% growth in total revenue, achieved through a balanced contribution from various business activities. Although trading and principal transactions have shown impressive growth, this source of income is more unstable and does not necessarily reflect the quality of the investment bank. What we find impressive is that even in the challenging trading environment of 2022, where M&A was down and IPO & leveraged finance markets were at a standstill, Jefferies was able to achieve over 10% growth in its IB fees compared to FY20.
Expenses have grown at a slower pace than revenue, showcasing the company’s effective cost management and the overall efficiency of the investment banking industry. The majority of costs are salaries, with the increase attributed to the increased workload of existing employees rather than a proportional rise in new hires for new projects.
Moving onto the balance sheet, we do not observe anything concerning. The leverage ratio of the business has remained flat across the last few periods, suggesting any decline in asset value has not materially changed the solvency of the business.
The business now considers its Merchant banking operations to be “non-core” having recently spun-off Vitesse Energy. The segment has performed fairly well, with many assets being realized more than book value. Management intends to continue the monetization of this segment, but this may be held up due to the remaining exposure being real estate heavy.
The number of employees has declined, driven in part by weakening conditions and a change in outlook. Further, the business has deconsolidated Merchant banking assets, including Idaho Timber. The IB industry is cutthroat and so we would not read too much into this.
As part of their Q4 results, Management announced their share buyback authorization would increase back to $250M. Over the last five years, Jefferies has returned $5.0 billion in total capital to shareholders, representing two-thirds of total tangible book value.
Tier 2 IB
Presented above is a cohort of non-bulge bracket investment banks, who are generally well regarded.
When comparing Jefferies to them based on profitability or growth, the business marginally underperforms. Of the 6 businesses listed, Jefferies is arguably the worst of them all. This is concerning to see as even if the business is attractive in isolation, investors may be foregoing far more attractive companies.
To assess this, we have considered the valuation these businesses are currently trading at.
Jefferies is currently trading in line with its cohort, offering a marginally superior dividend. Looking at Jefferies independently, this is likely driven by its growth in recent periods, alongside the shrewd deals within its Merchant arm. Relatively, one would suggest a discount needs to be applied to reflect the underperformance against the cohort.
Jefferies stock price is at a mini crossroads in our view. Performance is likely to decline in 2023 and potentially substantially depending on how the ECM/DCM markets play out. At the time of writing this, markets are quiet and many clients I speak to are expecting things to worsen. And yet, we see hope in the business.
The company is fundamentally strong. It is a leading IB, that has gained substantial market share from many of the larger players between 2020-2022. This will bring long-term benefits through additional services provided over time to its newfound clients. Further, its profitability profile is attractive, and its Merchant operations represent potentially undervalued assets.
With Sumitomo’s actions causing volatility in the company’s share price (up 14% YTD), our view would be to take a conservative view and rate this stock a hold.