BACKGROUND: Leucadia (LUK) is a diversified holding company engaged through its consolidated subsidiaries in a variety of businesses (which I’ll outline in a minute); the company is known among many as a “miniature Berkshire Hathaway” and has been run by Ian Cumming and Joseph Steinberg since December 1978.
At that time, shareholders’ equity was at a deficit of $7.66 million; at the end of fiscal year 2011, the company had positive shareholders’ equity of $6.17 billion, or $25.24 per share (this is substantially lower than it would have been if the company had not paid a special dividend of $812 million in 1999). In the past ten years, book value per share has increased at a rate of 13.3% per annum.
Mr. Cumming and Mr. Steinberg graduated in the class of 1970 from Harvard Business School, and together own nearly 20% of the company’s outstanding shares.
OPERATIONS
The company operates in a variety of areas, including beef processing, manufacturing, land-based contract oil and gas drilling, gaming entertainment, real estate activities, medical product development and winery operations. Leucadia also has investments in the common stock of a few publicly traded firms, including Jefferies Group (JEF, Financial) and Mueller Industries (MLI, Financial). Here’s a brief summary (although it might not seem so brief!) of the company’s key subsidiaries and investments (this was aggregated from the 2011 annual letter to shareholders and the 10-K):
NATIONAL BEEF
On Dec. 30, 2011, Leucadia paid $867.9 million for 79% of National Beef Packing (implied valuation of $1.1 billion for the entire business). National Beef holds a 14% share of the U.S.-fed beef market and processes more than 3.7 million head of cattle per year – equal to 5 billion pounds of live cattle! In National Beef’s last fiscal year (ended August 2011), the company generated $6.8 billion of revenues and $273.4 million of operating cash flow.
The other members of the partnership that owns National Beef are the previous owners – U.S. Premium Beef (USPB is comprised of cattle producers and is a major supplier to National Beef; they hold a 15% stake), NBPCo Holdings (NBPCo is a customer and a supplier of National Beef, and holds a 5% stake) and Tim Klein, National Beef’s CEO (owns about 1% of the company).
National Beef has five primary operating areas: Beef Processing (plants are “among the largest and most efficient plants in the industry”), Case Ready (processes and packages primal cuts into shelf ready products for large retail customers; management believes we are in the beginning stages of a trend toward case ready, which will be a win for all parties involved), Hide Tanning (takes cattle hides and processes them to create high quality wet blue leather for automotive interiors, handbags, furniture, etc), Kansas City Steak (sells high quality portioned beef directly to consumers via QVC, online, and catalog; hold a 75% stake, with the remaining 25% held by the founders), and Trucking (business is called National Carriers; delivers refrigerated products for National Beef and a variety of other customers).
As noted in the annual letter, National Beef’s value-added products command premium prices and meet customer product specifications based on quality, trim, weight, size, breed and other factors; the company’s unique cattle supply relationship with USPB provides a solid foundation for its value-added programs.
Management believes that as historically poor countries get richer they will demand higher-quality items – and more of them; this is applicable to global protein consumption. Global protein consumption is growing at “an astounding rate,” with U.S. beef exports up over 22% in 2011. By the way, the U.S. is not allowed to export beef directly to China – not yet, anyway.
BERKADIA COMMERICAL MORTGAGE LLC
Berkadia is a 50/50 JV with Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), and is one of the largest non-bank owned commercial mortgage servicers and commercial mortgage loan originators in the country.
Berkadia was originally capitalized in December 2009 with $434.3 million of partners’ equity, $217.2 million of which came from Leucadia. Through December 2011, the company has received dividends totaling $84.6 million, equal to nearly 40% of the original investment.
Even better, both cash flow and dividends grew in 2011 over 2010. From 2010 to 2011, the portfolio principal balance shrunk from $214 billion to $190 billion, which was expected as the company restructured in hopes of becoming the lowest cost servicing provider in the industry.
When Berkadia originates commercial loans for sale to investors, they typically retain the servicing rights. In 2011, Berkadia originated $5.2 billion of multifamily and commercial loans, up from $4.6 billion in 2010. The majority of these loans were multifamily loans sold to Fannie Mae, Freddie Mac, Ginnie Mae or the Federal Housing Administration, with Berkadia retaining the servicing rights. The more loans Berkadia can originate, the faster it will stabilize the servicing portfolio and the better the return on our investment.
INMET MINING CORPORATION
Leucadia is Inmet’s (TSX:IMN) largest individual shareholder with 11.04 million shares (16% of the company). During last year Inmet successfully ramped up production at the Cobre Las Cruces project in Spain, and passed a major milestone with the receipt and approval of the
Environmental and Social Impact Assessment by the government of Panama for its Cobre Panama project, a critical step for the development of Inmet’s large copper-gold deposit in Panama. Management is bullish on copper based on long-term supply-and-demand expectations.
FORTESCUE METALS GROUP
In August 2006, LUK invested $400 million in Fortescue Metals Group (ASX:FMG), which bought them 264 million shares of common stock and a $100 million 13-year unsecured note that receives 4% of the revenues from certain mine sites, net of government royalties.
A year later they invested another $44.2 million for 14 million additional shares. With the company’s equity infusion, Fortescue was able to raise $2.1 billion of debt that was used to develop its first mine, 260 kilometers of railway and a port large enough to ship 40 million metric tonnes of iron ore per annum. Since then, production has been expanded, and the infrastructure can now support 55 million metric tonnes per annum.
In 2011, Fortescue shipped a total of 46.5 million metric tonnes for $6.2 billion in revenue and in the fourth quarter shipped at a run rate of 57.7 tonnes per annum. Fortescue has announced plans to expand further to 155 tonnes per annum, 90 of which will come from the mines tied to the unsecured note mentioned above.
In 2011, the company sold 117.4 million shares of FMG for $732.2 million; this is equal to a compounded annual return of 32.7% based on the original purchase in August 2006. The company also earned $193 million in royalty payments under the note (to put that in perspective, that’s nearly twice the face value of the note). In the first quarter of 2012, management disposed of an additional 100 million shares for $506.5 million. Adding up dividends and stock sales and royalty payments, LUK has harvested to date $1.8 billion and still owns 30.59 million shares of Fortescue with a market value of roughly $186 million.
JEFFERIES GROUP
Jefferies is a full-service investment bank and institutional securities firm. Jefferies offers its customers capital markets executions, mergers and acquisitions, restructuring and other advisory services. As of Dec. 31, 2011, Leucadia owned 58 million Jefferies common shares (approximately 28.2% of all shares outstanding) for a total investment of $980.1 million. At year end, Leucadia carried Jefferies on its books at fair value of $797.6 million. Mr. Cumming and Mr. Steinberg are both on the board of directors at Jefferies.
In November 2011, in the wake of the MF Global bankruptcy, Jefferies was falsely accused of having a similarly illiquid and risky balance sheet. Rich Handler, Brian Friedman and management responded swiftly with transparency on the company’s position in eurozone sovereign debt, which stalled the stock’s free-fall; Leucadia jumped at the opportunity and added substantially to their stake in the company when the rumors first hit the street.
MUELLER
During 2011, the company acquired approximately 27.3% of the outstanding common shares of Mueller, a leading manufacturer of copper, brass, plastic and aluminum products, for aggregate cash consideration of $408.5 million.
PREMIER ENTERTAINMENT
Leucadia acquired the Hard Rock Hotel & Casino in Biloxi, Miss., in the wake of Hurricane Katrina. The casinos gaming revenues increased 3% in 2011, representing an increase in market share from 12.1% to 12.5%.
KEEN ENERGY SERVICES
Keen is a land-based oil and gas drilling operation based in Stillwater, Okla. The company was bought out in 2009 when Leucadia’s partners in the venture suffered liquidity issues; Keen owns high-horsepower rigs capable of directional drilling to find oil or shale gas (equally suited to drill for either). Keen management has followed the customers and the money, transitioning their rigs from 36% drilling for oil in 2010 to 60% in 2011. During that period, total rig utilization improved from 56% to 75% and dayrates increased, with the end result of operating cash flows more than doubling from 2010.
CRIMSON WINE GROUP
In the 2010 letter, management wrote, “We need more volume to make our goal of consistent, yearly cash flows a reality.” In May 2011, Leucadia acquired the Seghesio Family Vineyards, which includes 299 prime Zinfandel growing acres in Sonoma County, Calif., and gets the company on track to meet their volume needs: with annual sales of over 100,000 nine-liter equivalent cases, Seghesio increases the annual volume of Crimson Wine Group by nearly 70%. This additional volume provides Crimson with the scale and market power to improve margins and bring cash to the bottom line. The wineries primarily produce and sell wines in the premium, ultra-premium and luxury segments of the premium table wine market.
IDAHO TIMBER
As the housing market lagged again in 2011, pre-tax earnings at Idaho Timber (which are directly correlated to the cycles of the U.S. housing market) fell into negative territory, although operating cash flows were slightly positive. Idaho Timber has three primary business lines: remanufacturing of dimension lumber, value-added processing of home center boards and related items for large retailers, and primary sawmill production of radius-edge, southern pine decking and other specialty products. Each of these business lines is dependent on general construction and home improvement. Profitability in the remanufacturing business is highly dependent on the spread between prices of low-grade and high-grade lumber, which has narrowed due to increased Asian consumption of low-grade lumber and lower overall lumber production.
CONWED PLASTICS
Conwed Plastics manufactures and markets lightweight plastic netting for a variety of purposes (products sold throughout the world) and is a market leader in the sale of products used in carpet cushion, turf reinforcement, erosion control and packaging. Pre-tax earnings declined by 33% in 2011 as the price of polypropylene resin, the primary component of Conwed’s products, rose dramatically and remained elevated throughout the year. Leucadia has owned Conwed for 27 years and through several economic cycles, with the belief that this recent bout of input cost inflation shall pass. Over the years Leucadia has received a compounded return on invested capital of over 20% in the business.
SANGART
Sangart is developing a portfolio of biopharmaceutical products designed to enhance the oxygenation of oxygen deprived tissues through targeted oxygen delivery. Leucadia has invested $212 million in the business since they initial took a stake in 2003, and owns approximately 96% of the company. Sangart’s primary product (MP4OX) is designed to deliver oxygen to tissues, specifically as a result of trauma-induced injuries. In 2010, Sangart completed a Phase 2a trauma study involving 51 patients with results positive enough to induce us to fund the 2011 launch of a much more extensive Phase 2b study with approximately 360 patients (results expected near the end of 2012). Sangart has also developed a companion product, MP4CO, for use in sickle cell patients. In addition to carrying oxygen (like MP4OX), MP4CO also delivers carbon monoxide in non-toxic levels which is intended to prevent inflammation and programmed cell death (apoptosis). In 2011, Sangart launched a Phase 1b sickle cell study, focused on safety.
GARCADIA
Garcadia is a JV with Garff Enterprises Inc., a large Utah-based auto retailer. Together Leucadia and Garff purchase and turn around underperforming auto dealerships across the country (Leucadia provides the majority of the capital and some investing acumen and Garff manages the operations). Where possible, Leucadia purchases 100% of the underlying real estate and leases it back to the operation at a 10% net return. The partnership owns 17 dealerships in three geographic clusters: Des Moines, Iowa, Houston, Texas and Southern California. At Dec. 31, 2011, Leucadia’s net investment in Garcadia was $127.4 million, including real estate. Garcadia yielded cash flow to Leucadia of $11.4 million in 2011, inclusive of roughly $4.6 million spent on capital improvements to the real estate and excluding acquisitions. Even during the worst part of the recession, Garcadia returned cash to its partners.
LEUCADIA ENERGY – GASIFICATION
The company’s Lake Charles facility, located in Louisiana, has entered into two letters of intent and a contract with large credit-worthy customers for the vast majority of the plant’s output of methanol and industrial gases. These events allow the company to actively seek strategic partners to fully fund the project. Funding will be covered in part by $1.56 billion of tax exempt bonds, a $260 million federal grant for carbon capture and sequestration plus a $128 million federal investment tax credit. With engineering and early phase construction activities yet to be accomplished and a 36-month construction period, it will be years before this project returns cash to Leucadia’s coffers. The company has in-progress gasification projects in Indiana, Mississippi and Chicago; however, they have been stalled by the low price of natural gas.
OREGON LIQUIFIED NATURAL GAS
In January 2007, Leucadia acquired a leasehold interest and certain permits to construct and operate an onshore liquefied natural gas (LNG) receiving terminal in Warrenton, Oregon. Due to the sudden expansion in North American natural gas supplies, management is now evaluating construction of a facility focused on LNG exports.
With the natural gas market evolving and North America potentially becoming one of the world’s largest producers, LNG has an important role to play. Management believes that there is a payday at the end of the road for this business.
REAL ESTATE
The company’s net investment in the domestic real estate segment at year end was $246 million. For the most part, real estate development projects have been frozen for the time being, minimizing costs and in anticipation of a rebound in the market. Some of the notable properties are 708 acres in Panama City, Fla. (zoned for 3,200 residential units, 700,000 square feet of commercial space and 117 marina slips), raw land and finished residential lots in Myrtle Beach, and 15 acres of air rights above the train tracks behind Union Station in Washington, D.C.
VALUATION & INVESTMENT RATIONALE
As can be seen in the chart below, the common stock traded above book value for more than a decade (from 1999-2010), which is representative of the impressive increase in per share book value attained by the current management team:
As of the close on Monday, LUK common stock traded at a price of $23.94, equal to a price-to-book (as of 12/31/2011) of 0.95x; for a company that has increased book value per share at a rate of 18.5% per annum for more than a quarter century and has a trailing five-year average P/B of 1.42x, this looks like a valuation that merits further investigation.
First, let’s examine something from the 10-K: “Associated companies include equity interests in other entities that the Company accounts for under the equity method of accounting. Investments in associated companies that are accounted for under the equity method of accounting include HomeFed Corporation (“HomeFed”), a corporation engaged in real estate activities, Linkem S.p.A. (“Linkem”), a wireless broadband services provider in Italy, JHYH, Berkadia and Garcadia, a joint venture that owns automobile dealerships. Associated companies also include the Company’s investments in Jefferies and Mueller which are accounted for at fair value rather than under the equity method of accounting.”
To clarify, the equity method requires the investor (Leucadia) to initially report the investment at cost, and then make periodic adjustments that account for the investor’s proportional share of the associate company's net income (positive income increases the investment, and a net loss decreases the investment). In the investor’s income statement, the proportional share of the investee’s net income or net loss is reported as a single-line item.
However, for the company’s other two positions in Jefferies and Mueller, they are simply recorded at fair value, which is the market value of Leucadia’s stake at the balance sheet date. For example, the 28.2% stake in JEF was worth $797.5 million at year end, and the 27.3% stake in MLI was worth $400.4 million.
But that data is a bit dated; since the year began, Jefferies stock has increased by more than 23%, while Mueller has increased by more than 15% (Inmet & Fortescue are held as available for sale, but they have cumulatively been a wash YTD, so they weren’t included in this example). At the close on Monday, the companies position in Jefferies and Mueller were worth $987 million and $467 million, respectively; combined, that is roughly $250 million higher than what those positions were marked to at the end of 2011. Leaving all else constant, this adjustment results in an additional dollar per share of book value, bringing the current valuation down to 0.91x book value.
There are other areas where book value is a gross misrepresentation of intrinsic value; one great example is Sangart (mentioned above), which is developing a portfolio of biopharmaceutical products. As noted earlier, the company has invested $212 million in the business since 2003; yet on the balance sheet, the net book value of the company’s is less than a tenth of that amount, with cash spent on product development and clinical trials expensed through the income statement year after year (even though that clearly doesn’t reflect the economic reality). This same idea applies to energy projects, where the company has expensed costs to investigate, evaluate and obtain various permits and approvals of $33.9 million, $27.2 million, and $25.3 million during the years ended Dec. 31, 2011, 2010 and 2009, respectively.
Another example is Conwed Plastics, which Leucadia has owned since 1985; in the past five years, pre-tax income from that business has averaged more than $11.5 million annually, and ROIC has consistently exceeded 20%. In a private transaction, a business with those quantitative characterizes could easily fetch 8x pre-tax earnings power, or roughly $92 million; at the end of 2011, the net book value of the company’s investment in Conwed Plastics was $46.2 million, or roughly half of the estimated intrinsic value.
All this comes with an added kicker: the Fortescue note, which doesn’t mature for another seven years. Interest on the FMG Note is calculated as 4% of the revenue, net of government royalties, invoiced from the iron ore produced from the project’s Cloud Break and Christmas Creek areas, payable semi-annually within 30 days of June 30 and December 31 of each year. The company recorded interest income before withholding taxes on the FMG note of $214 million, $149 million and $66 million for the years 2011, 2010 and 2009, respectively.
Obviously, the future payout is dependent upon two items: the volume of iron shipped, and the prices on iron ore through 2018:
IRON ORE ESTIMATES
For the year ended Dec. 31, 2011, Fortescue sold 46.5 million metric tons of iron ore, entirely from Cloud Break and Christmas Creek. In 2011, Fortescue completed an expansion of its Cloud Break and Christmas Creek operations which will enable it to produce 55 million metric tons per annum.
In 2010, Fortescue announced a further expansion to increase its mining plan to 155 million metric tons per annum, with 90 million metric tons per annum coming from Cloud Break and Christmas Creek. Here is a chart outlying potential output from these two sites, assuming that it takes three years to reach projected capacity (one year longer than original project development):
Even though spot prices are up high single digits (percentage) year to date in anticipation of steel demand in China, let’s use the figures from 2011 to calculate Leucadia’s return per million tons:
$214 million / 46.5 million metric tons sold = $4.602 per metric ton
As I noted above, the spot price year to date is higher than that by 7% to 8%, but I’ll still take a 10% discount on the 2011 figure to provide an added cushion against price volatility over the coming years; with that, here’s our expected payout to LUK from the notes:
Cumulatively, the notes can reasonably be expected to generate $2 billion in value (closer to $2.4 billion at current spot prices) for shareholders over the next seven years (undiscounted); on a company with a market capitalization of less than $6 billion, that is material to say the least.
With that having been said, what would you be willing to pay for this note? As noted in the 10-K, the prepaid mining interest (which is classified as other current and non-current assets) has an aggregate balance of just $152 million; the disconnect between book and intrinsic value is clear.
The Fortescue note comes with one big red flag: In August 2010, Fortescue informed Leucadia that it believes it has the right to issue additional royalty notes in an unlimited amount, thereby diluting the company’s interest. On Sept. 1, 2010, Leucadia responded with a Writ of Summons against Fortescue, FMG and Fortescue’s then chief executive officer in the Supreme Court of Western Australia. The Writ of Summons seeks, among other things, an injunction restraining the issuance of any additional notes identical to the FMG Note and damages.
I’m not a legal expert and have no idea how this will play out; the great thing as an investor is that you receive the upside on this option without even paying for it (in the sense that this isn’t recognized on the balance sheet). The words of Mr. Cumming and Mr. Steinberg in the 2011 annual letter should provide some assurance on their confidence level: “We believe we are in good hands with our Australian lawyers and look forward to prevailing.”
These items all collectively form the basis of this investment: Leucadia is cheap at a 10% discount to book value due to the company’s proven ability to generate long-term value for shareholders (as reflect in the five-year historical P/B of 1.4x) and certain accounting conventions that shield the true economic (intrinsic) value of securities/subsidiaries on the balance sheet.
RISKS
It’s somewhat ironic that Leucadia is called a “mini Berkshire Hathaway” because both suffer from the same risk: The founder is leaving, and a successor will need to be picked to take the reins. In the most recent annual letter, Chairman Ian Cumming announced that he will not request a renewal of his employment contract, which ends in June 2015. Mr. Steinberg, the company’s president, is also reaching the age of retirement (he is currently 68) and will likely hang up his hat in the coming years. We are essentially left with the same question as at Berkshire: What will become of the empire once the king(s) have stepped down from the throne?
Personally, I think the answer is (and has been) clear. Warren Buffett’s speech, “The Superinvestors of Graham-and-Doddsville,” encapsulates this thinking in a way like no other: While the secret has been out for decades, few decide to follow a value-driven approach to investing. Mr. Cumming and Mr. Steinberg have built Leucadia based on these tenets, and I believe that it is safe to assume that they’ve surrounded themselves with individuals who are not only intelligent, but have the patience and mindset to continue implementing the strategy that has worked so well for investors in LUK over the past 33 years.
In the most recent annual letter, management specifically discussed Mr. Justin Wheeler (age 39), a Leucadia employee of 10+ years and the current Chief Operating Officer. For the past several years, Mr. Wheeler has run the company’s Asset Management Group, and was the “prime mover” behind the recent acquisition of National Beef. Mr. Cumming and Mr. Steinberg vocalized their thoughts on Mr. Wheeler to close out the letter: “Though both of us immensely enjoy what we do, we recognize our responsibility to plan for the future and expect Justin to be part of that future.”
The other obvious risk with an investment in Leucadia is that the Fortescue case doesn’t come out in the company’s favor, resulting in the loss of (what was almost certainly) hundreds of millions in returns on the FMG note. As I noted above, I’m not a legal expert, but I think that even this unfortunate outcome would have a limited effect on my overall opinion that LUK is an attractive security at the current valuation.
CONCLUSION
Just as Justice Potter Stewart found it impossible to test for obscenity but still proclaimed, "I know it when I see it,” the same can be said for Leucadia: I’m not sure what the shares are worth due the uncertainty surrounding the fair value of Jefferies & Mueller, in addition to the future of Sangart and the FMG note. However, I believe there’s an adequate margin of safety at the current valuation to say that it’s more than what the market is offering today.
At that time, shareholders’ equity was at a deficit of $7.66 million; at the end of fiscal year 2011, the company had positive shareholders’ equity of $6.17 billion, or $25.24 per share (this is substantially lower than it would have been if the company had not paid a special dividend of $812 million in 1999). In the past ten years, book value per share has increased at a rate of 13.3% per annum.
Mr. Cumming and Mr. Steinberg graduated in the class of 1970 from Harvard Business School, and together own nearly 20% of the company’s outstanding shares.
OPERATIONS
The company operates in a variety of areas, including beef processing, manufacturing, land-based contract oil and gas drilling, gaming entertainment, real estate activities, medical product development and winery operations. Leucadia also has investments in the common stock of a few publicly traded firms, including Jefferies Group (JEF, Financial) and Mueller Industries (MLI, Financial). Here’s a brief summary (although it might not seem so brief!) of the company’s key subsidiaries and investments (this was aggregated from the 2011 annual letter to shareholders and the 10-K):
NATIONAL BEEF
On Dec. 30, 2011, Leucadia paid $867.9 million for 79% of National Beef Packing (implied valuation of $1.1 billion for the entire business). National Beef holds a 14% share of the U.S.-fed beef market and processes more than 3.7 million head of cattle per year – equal to 5 billion pounds of live cattle! In National Beef’s last fiscal year (ended August 2011), the company generated $6.8 billion of revenues and $273.4 million of operating cash flow.
The other members of the partnership that owns National Beef are the previous owners – U.S. Premium Beef (USPB is comprised of cattle producers and is a major supplier to National Beef; they hold a 15% stake), NBPCo Holdings (NBPCo is a customer and a supplier of National Beef, and holds a 5% stake) and Tim Klein, National Beef’s CEO (owns about 1% of the company).
National Beef has five primary operating areas: Beef Processing (plants are “among the largest and most efficient plants in the industry”), Case Ready (processes and packages primal cuts into shelf ready products for large retail customers; management believes we are in the beginning stages of a trend toward case ready, which will be a win for all parties involved), Hide Tanning (takes cattle hides and processes them to create high quality wet blue leather for automotive interiors, handbags, furniture, etc), Kansas City Steak (sells high quality portioned beef directly to consumers via QVC, online, and catalog; hold a 75% stake, with the remaining 25% held by the founders), and Trucking (business is called National Carriers; delivers refrigerated products for National Beef and a variety of other customers).
As noted in the annual letter, National Beef’s value-added products command premium prices and meet customer product specifications based on quality, trim, weight, size, breed and other factors; the company’s unique cattle supply relationship with USPB provides a solid foundation for its value-added programs.
Management believes that as historically poor countries get richer they will demand higher-quality items – and more of them; this is applicable to global protein consumption. Global protein consumption is growing at “an astounding rate,” with U.S. beef exports up over 22% in 2011. By the way, the U.S. is not allowed to export beef directly to China – not yet, anyway.
BERKADIA COMMERICAL MORTGAGE LLC
Berkadia is a 50/50 JV with Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), and is one of the largest non-bank owned commercial mortgage servicers and commercial mortgage loan originators in the country.
Berkadia was originally capitalized in December 2009 with $434.3 million of partners’ equity, $217.2 million of which came from Leucadia. Through December 2011, the company has received dividends totaling $84.6 million, equal to nearly 40% of the original investment.
Even better, both cash flow and dividends grew in 2011 over 2010. From 2010 to 2011, the portfolio principal balance shrunk from $214 billion to $190 billion, which was expected as the company restructured in hopes of becoming the lowest cost servicing provider in the industry.
When Berkadia originates commercial loans for sale to investors, they typically retain the servicing rights. In 2011, Berkadia originated $5.2 billion of multifamily and commercial loans, up from $4.6 billion in 2010. The majority of these loans were multifamily loans sold to Fannie Mae, Freddie Mac, Ginnie Mae or the Federal Housing Administration, with Berkadia retaining the servicing rights. The more loans Berkadia can originate, the faster it will stabilize the servicing portfolio and the better the return on our investment.
INMET MINING CORPORATION
Leucadia is Inmet’s (TSX:IMN) largest individual shareholder with 11.04 million shares (16% of the company). During last year Inmet successfully ramped up production at the Cobre Las Cruces project in Spain, and passed a major milestone with the receipt and approval of the
Environmental and Social Impact Assessment by the government of Panama for its Cobre Panama project, a critical step for the development of Inmet’s large copper-gold deposit in Panama. Management is bullish on copper based on long-term supply-and-demand expectations.
FORTESCUE METALS GROUP
In August 2006, LUK invested $400 million in Fortescue Metals Group (ASX:FMG), which bought them 264 million shares of common stock and a $100 million 13-year unsecured note that receives 4% of the revenues from certain mine sites, net of government royalties.
A year later they invested another $44.2 million for 14 million additional shares. With the company’s equity infusion, Fortescue was able to raise $2.1 billion of debt that was used to develop its first mine, 260 kilometers of railway and a port large enough to ship 40 million metric tonnes of iron ore per annum. Since then, production has been expanded, and the infrastructure can now support 55 million metric tonnes per annum.
In 2011, Fortescue shipped a total of 46.5 million metric tonnes for $6.2 billion in revenue and in the fourth quarter shipped at a run rate of 57.7 tonnes per annum. Fortescue has announced plans to expand further to 155 tonnes per annum, 90 of which will come from the mines tied to the unsecured note mentioned above.
In 2011, the company sold 117.4 million shares of FMG for $732.2 million; this is equal to a compounded annual return of 32.7% based on the original purchase in August 2006. The company also earned $193 million in royalty payments under the note (to put that in perspective, that’s nearly twice the face value of the note). In the first quarter of 2012, management disposed of an additional 100 million shares for $506.5 million. Adding up dividends and stock sales and royalty payments, LUK has harvested to date $1.8 billion and still owns 30.59 million shares of Fortescue with a market value of roughly $186 million.
JEFFERIES GROUP
Jefferies is a full-service investment bank and institutional securities firm. Jefferies offers its customers capital markets executions, mergers and acquisitions, restructuring and other advisory services. As of Dec. 31, 2011, Leucadia owned 58 million Jefferies common shares (approximately 28.2% of all shares outstanding) for a total investment of $980.1 million. At year end, Leucadia carried Jefferies on its books at fair value of $797.6 million. Mr. Cumming and Mr. Steinberg are both on the board of directors at Jefferies.
In November 2011, in the wake of the MF Global bankruptcy, Jefferies was falsely accused of having a similarly illiquid and risky balance sheet. Rich Handler, Brian Friedman and management responded swiftly with transparency on the company’s position in eurozone sovereign debt, which stalled the stock’s free-fall; Leucadia jumped at the opportunity and added substantially to their stake in the company when the rumors first hit the street.
MUELLER
During 2011, the company acquired approximately 27.3% of the outstanding common shares of Mueller, a leading manufacturer of copper, brass, plastic and aluminum products, for aggregate cash consideration of $408.5 million.
PREMIER ENTERTAINMENT
Leucadia acquired the Hard Rock Hotel & Casino in Biloxi, Miss., in the wake of Hurricane Katrina. The casinos gaming revenues increased 3% in 2011, representing an increase in market share from 12.1% to 12.5%.
KEEN ENERGY SERVICES
Keen is a land-based oil and gas drilling operation based in Stillwater, Okla. The company was bought out in 2009 when Leucadia’s partners in the venture suffered liquidity issues; Keen owns high-horsepower rigs capable of directional drilling to find oil or shale gas (equally suited to drill for either). Keen management has followed the customers and the money, transitioning their rigs from 36% drilling for oil in 2010 to 60% in 2011. During that period, total rig utilization improved from 56% to 75% and dayrates increased, with the end result of operating cash flows more than doubling from 2010.
CRIMSON WINE GROUP
In the 2010 letter, management wrote, “We need more volume to make our goal of consistent, yearly cash flows a reality.” In May 2011, Leucadia acquired the Seghesio Family Vineyards, which includes 299 prime Zinfandel growing acres in Sonoma County, Calif., and gets the company on track to meet their volume needs: with annual sales of over 100,000 nine-liter equivalent cases, Seghesio increases the annual volume of Crimson Wine Group by nearly 70%. This additional volume provides Crimson with the scale and market power to improve margins and bring cash to the bottom line. The wineries primarily produce and sell wines in the premium, ultra-premium and luxury segments of the premium table wine market.
IDAHO TIMBER
As the housing market lagged again in 2011, pre-tax earnings at Idaho Timber (which are directly correlated to the cycles of the U.S. housing market) fell into negative territory, although operating cash flows were slightly positive. Idaho Timber has three primary business lines: remanufacturing of dimension lumber, value-added processing of home center boards and related items for large retailers, and primary sawmill production of radius-edge, southern pine decking and other specialty products. Each of these business lines is dependent on general construction and home improvement. Profitability in the remanufacturing business is highly dependent on the spread between prices of low-grade and high-grade lumber, which has narrowed due to increased Asian consumption of low-grade lumber and lower overall lumber production.
CONWED PLASTICS
Conwed Plastics manufactures and markets lightweight plastic netting for a variety of purposes (products sold throughout the world) and is a market leader in the sale of products used in carpet cushion, turf reinforcement, erosion control and packaging. Pre-tax earnings declined by 33% in 2011 as the price of polypropylene resin, the primary component of Conwed’s products, rose dramatically and remained elevated throughout the year. Leucadia has owned Conwed for 27 years and through several economic cycles, with the belief that this recent bout of input cost inflation shall pass. Over the years Leucadia has received a compounded return on invested capital of over 20% in the business.
SANGART
Sangart is developing a portfolio of biopharmaceutical products designed to enhance the oxygenation of oxygen deprived tissues through targeted oxygen delivery. Leucadia has invested $212 million in the business since they initial took a stake in 2003, and owns approximately 96% of the company. Sangart’s primary product (MP4OX) is designed to deliver oxygen to tissues, specifically as a result of trauma-induced injuries. In 2010, Sangart completed a Phase 2a trauma study involving 51 patients with results positive enough to induce us to fund the 2011 launch of a much more extensive Phase 2b study with approximately 360 patients (results expected near the end of 2012). Sangart has also developed a companion product, MP4CO, for use in sickle cell patients. In addition to carrying oxygen (like MP4OX), MP4CO also delivers carbon monoxide in non-toxic levels which is intended to prevent inflammation and programmed cell death (apoptosis). In 2011, Sangart launched a Phase 1b sickle cell study, focused on safety.
GARCADIA
Garcadia is a JV with Garff Enterprises Inc., a large Utah-based auto retailer. Together Leucadia and Garff purchase and turn around underperforming auto dealerships across the country (Leucadia provides the majority of the capital and some investing acumen and Garff manages the operations). Where possible, Leucadia purchases 100% of the underlying real estate and leases it back to the operation at a 10% net return. The partnership owns 17 dealerships in three geographic clusters: Des Moines, Iowa, Houston, Texas and Southern California. At Dec. 31, 2011, Leucadia’s net investment in Garcadia was $127.4 million, including real estate. Garcadia yielded cash flow to Leucadia of $11.4 million in 2011, inclusive of roughly $4.6 million spent on capital improvements to the real estate and excluding acquisitions. Even during the worst part of the recession, Garcadia returned cash to its partners.
LEUCADIA ENERGY – GASIFICATION
The company’s Lake Charles facility, located in Louisiana, has entered into two letters of intent and a contract with large credit-worthy customers for the vast majority of the plant’s output of methanol and industrial gases. These events allow the company to actively seek strategic partners to fully fund the project. Funding will be covered in part by $1.56 billion of tax exempt bonds, a $260 million federal grant for carbon capture and sequestration plus a $128 million federal investment tax credit. With engineering and early phase construction activities yet to be accomplished and a 36-month construction period, it will be years before this project returns cash to Leucadia’s coffers. The company has in-progress gasification projects in Indiana, Mississippi and Chicago; however, they have been stalled by the low price of natural gas.
OREGON LIQUIFIED NATURAL GAS
In January 2007, Leucadia acquired a leasehold interest and certain permits to construct and operate an onshore liquefied natural gas (LNG) receiving terminal in Warrenton, Oregon. Due to the sudden expansion in North American natural gas supplies, management is now evaluating construction of a facility focused on LNG exports.
With the natural gas market evolving and North America potentially becoming one of the world’s largest producers, LNG has an important role to play. Management believes that there is a payday at the end of the road for this business.
REAL ESTATE
The company’s net investment in the domestic real estate segment at year end was $246 million. For the most part, real estate development projects have been frozen for the time being, minimizing costs and in anticipation of a rebound in the market. Some of the notable properties are 708 acres in Panama City, Fla. (zoned for 3,200 residential units, 700,000 square feet of commercial space and 117 marina slips), raw land and finished residential lots in Myrtle Beach, and 15 acres of air rights above the train tracks behind Union Station in Washington, D.C.
VALUATION & INVESTMENT RATIONALE
As can be seen in the chart below, the common stock traded above book value for more than a decade (from 1999-2010), which is representative of the impressive increase in per share book value attained by the current management team:
As of the close on Monday, LUK common stock traded at a price of $23.94, equal to a price-to-book (as of 12/31/2011) of 0.95x; for a company that has increased book value per share at a rate of 18.5% per annum for more than a quarter century and has a trailing five-year average P/B of 1.42x, this looks like a valuation that merits further investigation.
First, let’s examine something from the 10-K: “Associated companies include equity interests in other entities that the Company accounts for under the equity method of accounting. Investments in associated companies that are accounted for under the equity method of accounting include HomeFed Corporation (“HomeFed”), a corporation engaged in real estate activities, Linkem S.p.A. (“Linkem”), a wireless broadband services provider in Italy, JHYH, Berkadia and Garcadia, a joint venture that owns automobile dealerships. Associated companies also include the Company’s investments in Jefferies and Mueller which are accounted for at fair value rather than under the equity method of accounting.”
To clarify, the equity method requires the investor (Leucadia) to initially report the investment at cost, and then make periodic adjustments that account for the investor’s proportional share of the associate company's net income (positive income increases the investment, and a net loss decreases the investment). In the investor’s income statement, the proportional share of the investee’s net income or net loss is reported as a single-line item.
However, for the company’s other two positions in Jefferies and Mueller, they are simply recorded at fair value, which is the market value of Leucadia’s stake at the balance sheet date. For example, the 28.2% stake in JEF was worth $797.5 million at year end, and the 27.3% stake in MLI was worth $400.4 million.
But that data is a bit dated; since the year began, Jefferies stock has increased by more than 23%, while Mueller has increased by more than 15% (Inmet & Fortescue are held as available for sale, but they have cumulatively been a wash YTD, so they weren’t included in this example). At the close on Monday, the companies position in Jefferies and Mueller were worth $987 million and $467 million, respectively; combined, that is roughly $250 million higher than what those positions were marked to at the end of 2011. Leaving all else constant, this adjustment results in an additional dollar per share of book value, bringing the current valuation down to 0.91x book value.
There are other areas where book value is a gross misrepresentation of intrinsic value; one great example is Sangart (mentioned above), which is developing a portfolio of biopharmaceutical products. As noted earlier, the company has invested $212 million in the business since 2003; yet on the balance sheet, the net book value of the company’s is less than a tenth of that amount, with cash spent on product development and clinical trials expensed through the income statement year after year (even though that clearly doesn’t reflect the economic reality). This same idea applies to energy projects, where the company has expensed costs to investigate, evaluate and obtain various permits and approvals of $33.9 million, $27.2 million, and $25.3 million during the years ended Dec. 31, 2011, 2010 and 2009, respectively.
Another example is Conwed Plastics, which Leucadia has owned since 1985; in the past five years, pre-tax income from that business has averaged more than $11.5 million annually, and ROIC has consistently exceeded 20%. In a private transaction, a business with those quantitative characterizes could easily fetch 8x pre-tax earnings power, or roughly $92 million; at the end of 2011, the net book value of the company’s investment in Conwed Plastics was $46.2 million, or roughly half of the estimated intrinsic value.
All this comes with an added kicker: the Fortescue note, which doesn’t mature for another seven years. Interest on the FMG Note is calculated as 4% of the revenue, net of government royalties, invoiced from the iron ore produced from the project’s Cloud Break and Christmas Creek areas, payable semi-annually within 30 days of June 30 and December 31 of each year. The company recorded interest income before withholding taxes on the FMG note of $214 million, $149 million and $66 million for the years 2011, 2010 and 2009, respectively.
Obviously, the future payout is dependent upon two items: the volume of iron shipped, and the prices on iron ore through 2018:
IRON ORE ESTIMATES
For the year ended Dec. 31, 2011, Fortescue sold 46.5 million metric tons of iron ore, entirely from Cloud Break and Christmas Creek. In 2011, Fortescue completed an expansion of its Cloud Break and Christmas Creek operations which will enable it to produce 55 million metric tons per annum.
In 2010, Fortescue announced a further expansion to increase its mining plan to 155 million metric tons per annum, with 90 million metric tons per annum coming from Cloud Break and Christmas Creek. Here is a chart outlying potential output from these two sites, assuming that it takes three years to reach projected capacity (one year longer than original project development):
| 2012 | 2013 | 2014 | 2015 | 2016 | 2017 | 2018 |
| 55M | 55M | 55M | 90M | 90M | 90M | 90M |
Even though spot prices are up high single digits (percentage) year to date in anticipation of steel demand in China, let’s use the figures from 2011 to calculate Leucadia’s return per million tons:
$214 million / 46.5 million metric tons sold = $4.602 per metric ton
As I noted above, the spot price year to date is higher than that by 7% to 8%, but I’ll still take a 10% discount on the 2011 figure to provide an added cushion against price volatility over the coming years; with that, here’s our expected payout to LUK from the notes:
| 2012 | 2013 | 2014 | 2015 | 2016 | 2017 | 2018 |
| $228M | $228M | $228M | $373M | $373M | $373M | $373M |
Cumulatively, the notes can reasonably be expected to generate $2 billion in value (closer to $2.4 billion at current spot prices) for shareholders over the next seven years (undiscounted); on a company with a market capitalization of less than $6 billion, that is material to say the least.
With that having been said, what would you be willing to pay for this note? As noted in the 10-K, the prepaid mining interest (which is classified as other current and non-current assets) has an aggregate balance of just $152 million; the disconnect between book and intrinsic value is clear.
The Fortescue note comes with one big red flag: In August 2010, Fortescue informed Leucadia that it believes it has the right to issue additional royalty notes in an unlimited amount, thereby diluting the company’s interest. On Sept. 1, 2010, Leucadia responded with a Writ of Summons against Fortescue, FMG and Fortescue’s then chief executive officer in the Supreme Court of Western Australia. The Writ of Summons seeks, among other things, an injunction restraining the issuance of any additional notes identical to the FMG Note and damages.
I’m not a legal expert and have no idea how this will play out; the great thing as an investor is that you receive the upside on this option without even paying for it (in the sense that this isn’t recognized on the balance sheet). The words of Mr. Cumming and Mr. Steinberg in the 2011 annual letter should provide some assurance on their confidence level: “We believe we are in good hands with our Australian lawyers and look forward to prevailing.”
These items all collectively form the basis of this investment: Leucadia is cheap at a 10% discount to book value due to the company’s proven ability to generate long-term value for shareholders (as reflect in the five-year historical P/B of 1.4x) and certain accounting conventions that shield the true economic (intrinsic) value of securities/subsidiaries on the balance sheet.
RISKS
It’s somewhat ironic that Leucadia is called a “mini Berkshire Hathaway” because both suffer from the same risk: The founder is leaving, and a successor will need to be picked to take the reins. In the most recent annual letter, Chairman Ian Cumming announced that he will not request a renewal of his employment contract, which ends in June 2015. Mr. Steinberg, the company’s president, is also reaching the age of retirement (he is currently 68) and will likely hang up his hat in the coming years. We are essentially left with the same question as at Berkshire: What will become of the empire once the king(s) have stepped down from the throne?
Personally, I think the answer is (and has been) clear. Warren Buffett’s speech, “The Superinvestors of Graham-and-Doddsville,” encapsulates this thinking in a way like no other: While the secret has been out for decades, few decide to follow a value-driven approach to investing. Mr. Cumming and Mr. Steinberg have built Leucadia based on these tenets, and I believe that it is safe to assume that they’ve surrounded themselves with individuals who are not only intelligent, but have the patience and mindset to continue implementing the strategy that has worked so well for investors in LUK over the past 33 years.
In the most recent annual letter, management specifically discussed Mr. Justin Wheeler (age 39), a Leucadia employee of 10+ years and the current Chief Operating Officer. For the past several years, Mr. Wheeler has run the company’s Asset Management Group, and was the “prime mover” behind the recent acquisition of National Beef. Mr. Cumming and Mr. Steinberg vocalized their thoughts on Mr. Wheeler to close out the letter: “Though both of us immensely enjoy what we do, we recognize our responsibility to plan for the future and expect Justin to be part of that future.”
The other obvious risk with an investment in Leucadia is that the Fortescue case doesn’t come out in the company’s favor, resulting in the loss of (what was almost certainly) hundreds of millions in returns on the FMG note. As I noted above, I’m not a legal expert, but I think that even this unfortunate outcome would have a limited effect on my overall opinion that LUK is an attractive security at the current valuation.
CONCLUSION
Just as Justice Potter Stewart found it impossible to test for obscenity but still proclaimed, "I know it when I see it,” the same can be said for Leucadia: I’m not sure what the shares are worth due the uncertainty surrounding the fair value of Jefferies & Mueller, in addition to the future of Sangart and the FMG note. However, I believe there’s an adequate margin of safety at the current valuation to say that it’s more than what the market is offering today.
