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 September 17, 2015 - 9:32 AM EDT
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Fitch: Jefferies' Weak 3Q15 Results Extend Challenging Twelve Month Stretch

The meaningful energy distressed debt trading losses reported today by Jefferies Group LLC (Jefferies) dragged down overall fiscal third 2015 (3Q'15) results. The trailing twelve month period was characterized, in Fitch Ratings' opinion, by continued pressure on the company's distressed debt trading business and elevated costs associated with the company's nearly-complete divestiture of the Bache futures and commodities business.

The latest results have no immediate rating impact on Jefferies' 'BBB-/F3' ratings or Stable Outlook, given the company's relatively conservative leverage and liquidity profiles, the manageable size of the losses relative to overall earnings capacity, relative stability in Jefferies' investment banking and equity sales and trading businesses, and the reduction in inventory positions that drove trading losses. Market volatility exposure that characterizes the securities firm business model is a key rating constraint that is incorporated in Jefferies' current ratings. However, sustained underperformance in business segments or further outsized trading losses would pressure ratings.

Jefferies' reported net income of $2.0 million for 3Q'15, compared with $59.8 million and $83.6 million for 2Q'15 and 3Q'14, respectively. The decline was primarily attributable to negative fixed income sales and trading revenues of $18.2 million for the quarter, compared to revenue of $153.4 million and $195.3 million in 2Q'15 and 3Q'14, respectively. Poor results in this segment were driven by realized and unrealized losses on distressed debt inventory positions related to the energy sector, and in particular, oil and gas. The company attributed the losses to declining oil prices and recent market volatility resulting from news of China's slowing economic growth, although Jefferies' active role on the distressed debt trading space likely further exacerbated the impact.

The third quarter trading losses come on the back of significant mark-to-market write-downs experienced by the firm's fixed income segment during the broad high yield sell off in October 2014. The reoccurrence underscores Fitch's belief that Jefferies' distressed debt market making business creates inventory concentration issues and exposes the firm to the risk of inventory write downs in times of market disruptions. Jefferies indicated that it reduced its net distressed energy position by approximately 50% during the quarter, down to $70 million at quarter-end. Although the reduction in the absolute level of exposure is viewed positively, there remains the possibility for additional losses emanating from the remaining positions.

Jefferies is rapidly approaching the completion of its announced divestiture of the Bache futures and commodities business, contributing to the overall balance sheet reduction in the quarter. Remaining costs related to the wind down are expected to be less than $10 million on an after tax basis. While the Bache business proved to be a strategic misstep for Jefferies, Fitch views the wind-down of positively from the perspectives of eliminating a persistent drag on earnings and allowing Jefferies to focus on its core businesses going forward.

Strong results in the core equities trading business and investment banking shed some positive light on the quarter. Investment banking, which includes capital markets (equity and debt) and mergers & acquisitions advisory (M&A) had solid revenues of $389.8 million, down a modest 3.5% from the previous quarter but down 16.7% year-on-year. Jefferies indicated that its investment banking backlog remains robust which should bode well for future earnings from the segment, although in Fitch's opinion, Jefferies' energy investment banking backlog may experience pressure. Equities trading revenues for the period were $203.1 million, up from $171.7 million in 3Q'14 despite a sell-off in global markets in August.

Risk in Jefferies' trading book, as measured by value-at-risk (VaR), increased slightly quarter-on-quarter with an increase in market volatility partially offset by a 30% reduction in the firm's stake in KCG through a June tender offer which yielded sale proceeds of $91 million. The number of trading loss days during the quarter increased significantly to 21 in 3Q'15 compared with 10 in 2Q'15, largely attributable to the firm's distressed debt positions and equity market volatility. Total assets declined 3.2% to $42.8 billion from $44.1 billion in 2Q'15 with a reduction in Bache assets to $0.3 billion from $3.0 billion in 2Q'15 partially offset by an increase in cash. Jefferies-calculated adjusted leverage (defined as tangible assets minus reverse repo and securities borrowed divided by tangible equity) was flat at 10.3x at Aug. 31, 2015, consistent with 2Q'15.

Jefferies-calculated liquidity, which includes cash, cash equivalents, high-quality government securities and reverse repurchase agreements collateralized by high-quality government securities, of $5.2 billion represented 12.0% of assets, while cash and equivalents comprised 8.0% of assets, in line with prior quarters.

Jefferies, a Delaware-incorporated holding company, is a full-service investment banking and institutional securities firm primarily serving middle-market clients and investors. Its primary broker/dealer operating subsidiary, Jefferies LLC, holds the vast majority of the firm's consolidated assets and is regulated by the SEC. At Aug. 31, 2015, Jefferies had U.S. GAAP total assets of $42.8 billion and members' equity of $5.5 billion (including non-controlling interests and $1.9 billion of goodwill). Fitch considers Jefferies to be a core subsidiary of Leucadia National Corp. (Leucadia, 'BBB-', Outlook Stable) based on Jefferies' significance relative to Leucadia's equity and the role it is expected to continue playing in the combined company's future strategic direction.

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Fitch Ratings
Nathan Flanders
Managing Director
+1-212-908-0827
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Joo-Yung Lee
Managing Director
+1-212-908-0560
or
Media Relations:
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alyssa.castelli@fitchratings.com


Source: Business Wire (September 17, 2015 - 9:32 AM EDT)

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