Leucadia: A Smart Hedge To Protect Your Stock Portfolio

During the 3rd quarter 2006 the S&P 500 companies will enjoy their 18th consecutive quarter of double digit profit increase and analysts expect another double digit profit increase during the whole year 2007. Since the S&P 500 profits already reached an eye popping 49 years record level of 8.6% of GDP (total of product and services created by U.S. residents) there is some room for disappointment.

Since it's better worry about the storm when the sun is still shining, it's now the right time to wonder on how to hedge your stock portfolio against possible mediocre stock market returns.

The two major alternatives are:
- purchase of put options (or other options strategies): I tend to exclude this solution since protection is limited and cost (including commission and bid/ask spread) is expensive.
- diversifying in bonds or cash: short term investment grades bonds, U.S. Treasuries or cash do offer a limited reward (though about 2% over current inflation rate is historically a good level for cash equivalent investments), long term bonds at 4.8/5.5% do not offer an attractive reward and inflation protection. Spread of junk bonds over corporates are close to an historical low.

And what about an attractive third alternative: buying shares of a company which is thriving when the economy go bad but offers at the same time a long term track record of superior returns ?
This company exists: it's called Leucadia.


PROFILE

Key numbers (source: Yahoo)
Leucadia (LUK)
last quote (closing 10/24/06): $26.15
outstanding shares: $216 mil.
market cap: $5.66 bil.
P/E: 12.20
P/B: 1.49
dividend yield: 0.50%

Leucadia is often referred as a mini-Berkshire, the holding company of famed value investor Warren Buffett.
Though the company is described by S&P as a "Multi-Sector Holding" company, Leucadia looks more like a private equity firm.
Contrary to Warren Buffett favourite investment strategy, they are not chasing great companies available at acceptable valuations and hold them for a very long period.
They concentrate on deep value investments in distressed or out of favor assets often, but not always, involving bankrupt companies.
They usually prefer to move within their circle of competence which includes, among others, telecommunications, lending/banking, real-estate and mining industry.
Once they control the company they turn it around and sell it for what have been historically excess returns.

period 1979-2005	S&P 500	Leucadia
CAGR (1) index/share prices change (2)	+ 9.9%	+ 25.1%
CAGR Shareholders equity	N/A	+ 21.5%

(1) CAGR: compound annual growth rate
(2) includes dividends for S&P 500, excludes dividends for Leucadia
source: Leucadia Shareholders Letter 2005



comparison chart Leucadia - Berkshire Hathaway - S&P 500

The shop is run by Ian Cumming (Chairman of the Board) and Joseph Steinberg (President) which are deemed to be responsible of this notable long term performance.


BALANCE SHEET

Balance sheet is extremely liquid at the moment.
Long term debt stands at about 1 billion against 1.4 billion of net currents assets (which includes about 1.6 billion cash in cash or short term investment) and 3.8 billion of shareholders equity.
Hopefully in the next months at least part of this cash balance will be used in various investments opportunities.

One of the major assets items is a net Deferred Tax Assets worth about 1 billion which requires additional comment.
In 2005, following the sale of their telecom company WilTel to Level 3, Leucadia kept some assets in hands including this Deferred Tax Assets.
Since WilTel has accumulated about $5.1 bil. losses it accrued a credit on future federal income taxes of about $1.0 bil. which can be used to offset Leucadia profits on future investments at certain conditions for a period of about 20 years.

Each year, every time that Leucadia will accrue eligible profits:
- balance sheet Deferred Tax Assets will be reduced in proportion on federal taxes that the company should have paid on its profits,
- in Income Statement, a tax expense will RECORDED but not PAID.

Note that to ascertain the true company profitability in the future you should add back the non-cash federal taxes to the net profit reported until the whole Deferred Tax Asset will be used.

After checking company investment track record and company statements we based our analysis of net worth on the assumption that in the next 15-20 years Leucadia will generate enough taxable income to fully take advantage of the tax credit assets reported in balance sheet.


MANAGEMENT

Top management, Ian Cumming and Joseph Steinberg, are the main point of strength of the company. They are responsible for the stellar long term investment returns but they are 62 and 66 year old. However their new employment contract signed in 2005 expires in June 2015. They are in good health and according to what can be understood from their comments in last shareholders letter and last shareholders meeting they seem as enthusiasts as ever.
They own about 24% of the company which is a good guarantee that they will move in line with long term shareholders interest.

This summer there have a been some notable insider buying. Two directors bought shares worth about $534.000 at an average price of $25.74, a level close to present quote.


AN UNDERGROUND WEALTH BUILDER

Leucadia is not an ordinary conglomerate and its profitability is not easy to ascertain by following their quarterly earnings releases. Wealth is not built by a regular stream of operating income out of of long term assets. Management goal is to increase over time the company net worth which usually does not appear in balance sheet or income statement till the assets sale.
In the past most of their investments were concentrated in private companies or hard/financial assets which fair value is elusive for analyst not specifically involved in the relevant industry.

How to evaluate the business ? The main criteria should be, like an ordinary stock mutual fund, the Net Asset Value. But unlike a mutual fund, usually you cannot rely on daily market prices of listed stocks or bonds since their assets are not always publicly listed .

A deep and relevant analysis would be so time consuming that brokerage houses and investment banks decided not to cover the company despite its $5.7 mil. market cap. It tells a lot on how poor is Wall Street job on providing added value information on balance sheet statements and how much time and money are spent on trying to get right up to the penny the quarterly earning figures.

However you are now in a somehow lucky period regarding this issue since more than half of total assets are made of cash and short terms investments.
Out of total $5.5 bil. total assets appearing in last balance sheet for quarter ending June 2006 you have about 2 bil. of cash and short term investments and about 1 bil. of deferred tax assets (see above) which require no adjustment to reflect their fair value.

On top of that financial statements report a collection of minor assets which adjustment to get fair value would have only a very minor impact on reported balance sheet for two reasons:
- assets were acquired a short time ago (less than 1 year/1 year and half ago)
- they represent a minor share of total company assets

Here are the main assets excluding cash:

• $400 mil. invested in Fortescue, an Australian iron ore mining company ($300 equity and a $100 mil. note);
• timber and plastics manufacturing: paid $133 mil. in Apr.05 for Idaho Timber plus Conwed (plastics) which employed about $82 mil. assets;
• wineries located in California (225 acres in Napa Valley) and Oregon (115 acres in Willamette Valley), combined net investments amount to $71 mil.;
• real estate assets which book value at the end December 2005 was $166. I suppose that these assets should be materially undervalued. Accounting rules require to depreciate such assets though they tend to increase their value over time especially these last 3-4 years of white-hot real estate market;
• restricted 5.6 mil. shares of Canadian mining company INMET (worth today $ 265 mil. against $78 mil. reported in the books);
• a 30% interest in Goober Drilling paid $60 mil., plus a secured loan to the same company of $126 mil. (loan balance was $53 mil. in June 2006);
• $91 mil. investment to rebuild the Hard Rock Biloxi casino and hotel completely destroyed during Hurricane Katrina;
• about $250 mil. in a various hedge-funds and investment partnerships;
• Berkadia (it sounds like a joint-venture between Berkshire and Leucadia ? you're right, it is) which is close to complete the liquidation of assets of bankrupt Finova Capital Corporation.

After adjusting for market value of Inmet and real estate assets and after deducting unfunded defined benefit pension plans (calculated by Leucadia using a very conservative discount rate around 5.1%) and adjusted marked to market value of Fortescue equity I estimate that stock is trading at about 1.40 times adjusted B/V, more or less in line with the 1.50 times book value calculated as per official financial statements.

If you decide to buy the stock and want to follow the company investments or if you are willing to do some further research I highly recommend to read Leucadia candid, detailed and well written shareholders letters. You will have a good feel on how assets are performing and how management intend to move to allocate capital without the burden of time consuming assets valuations.

Since last summer, despite a buoyant stock market, shares have been performing poorly. The reason is that since Cumming and Steinberg have a strong investment discipline and they are not finding enough attractively priced distressed assets . The reason is that "competition for investment opportunities, roared back in the form of 35-year old hedge fund managers-private equity firms who have never known a bear market-and other investors willing to invest at high prices in risky assets with seemingly cheap money (they cite in their 2004 shareholders letter as example an ebullient junk bond market" and "hot potato loan market").
In the same 2004 shareholders letter, Cumming and Steinberg have been clear on their investing discipline: "either we invest in high returning opportunities or have the money in the bank or under our mattresses". At that time lack of opportunities induced a pessimistic tone: "if we run out of ideas or steam we will let you know and develop a plan to return money to shareholders" they said.

However their comments in their 2005 shareholders letter and during their shareholders meeting in spring 2006 were somehow more optimistic: "We have many things in the hopper that look interesting and hopefully by next year at this time we will have a measurable reduction in cash and an increase in higher yielding investments."

Since U.S. market of distressed assets seems ultra competitive due to hedge funds and private equity funds abundance of cash, Leucadia is looking more at foreign investments. Fortescue deal is a first step in this direction.


RISKS

If management is unable to finalize an attractive deals pipeline worth at least $2-3 bil., company will be unable to compound shareholders equity at the present 20% long term average rate and Deferred Tax Asset may loose value.

Foreign investments may prove less profitable than the U.S. distressed assets deals which historically have been the company bread and butter and the main source of profits.


CONCLUSION

If management is able to match even 3/4 of their historical investment returns paying present 1.4/1.5 book value seems a fair price. Don't forget that in this price you also have included a free built-in hedge since the worse the economy, the more opportunities for Leucadia to profitably invest their large cash hoard.

I plan to plan to buy a 1/3rd or 1/2 position at around $25.50/26.00 per share.



Disclosure: the author has no position in Leucadia at the time of posting.
Under no circumstances does the information in this post represents a recommendation to buy or sell stocks. Such information must be considered only as first step for further research.

Disclosure on my previous post on DELL

Further some editing troubles on my previous post on DELL following disclosure has been omitted.


" Disclosure:
It is not intended as a recommendation (or advice) to buy or sell securities.
Author is long DELL at the time of posting. Security positions may change at any time. "

Is DELL Too Cheap Not To Own ?

Negativity abounds around DELL.

Earnings warnings, 4.1 mil. laptops recall due to battery defect, SEC investigation on accounting issues, fierce competition against a reshaped Hewlett Packard and aggressive Far East boxmakers, poor customer service and depressed margins disappointed investors.

DELL shares crashed accordingly from the low forties to reach briefly a 5 years at around USD 19 in July. Since then the stock trades in a range between about $20 and $23.

Discounting weakness in business model in the foreseeable future, company is reaching today extreme low valuations.
Since 1997 DELL traded at the end of its fiscal years (ending Juanuary) at an average of 2.8 P/S ratio (min 1.28 end of FY 2006, source: MSN Money). At today current quote (around $23) DELL fetch a 0.9 P/S ratio.
Though a single rough ratio does not give a complete picture I think that at a normalized sales growth rate and profit margins, both lower than their long term average, DELL may be a safe and cheap investment at slightly below the present quote.


1) PROFILE

DELL is the world leader of PC makers. The company founded by its present president Michael Dell in his college dorm room in 1984 fetched 10.5% worldwide PC market share in FY 2000, today it reached at around 19%.
Note that Michael Dell till owns a bit more than 10% of total shares outstanding.

Excluding the networking business, DELL is the market leader in all geographical areas except Japan (no.2) and Asia-Pacific (which includes India and Cina and where DELL is no3. but gaining market share).

In U.S. DELL is the leader in all the clients segments (education, government, home, large and small business) with 34% market share.

Revenues in trailing 4 quarters are 57.4 Bil.

Business segments revenue breakdown (MRQ):
- desktops and mobility (mainly laptops): 61%
- software and peripherals: 16%
- servers and networking: 10%
- services (product warranties, training ...): 9%
- storage: about 3%
DELL does not disclose operating margins for each business line.

Geographical revenue breakdown (and year over year sales growth, MRQ):
- Americas: 65% (+3%)
- Europe: 21% (+3%)
- Asia-Pacific-Japan 14% (+17%)

Success of DELL has been driven by :
- 1) Their unique direct sale / build-to-order model which allows them to eliminate wholesalers and retailers margins and having a real-time feel on market needs and avoid inventory glut at the retailers level.
Cash from their sales is also directly reaching their coffers without being delayed in intermediate distribution channels.
- 2) An obsessive focus on continuously improving their best in class manufacturing and supply chain management practices. This manufacturing global giant is able to have an average of 5 days of inventory in stock only. They are therefore the first to introduce new components and the first to pass to their customers the savings of PC components which are in a secular downtrend prices.
They are also avoiding the high obsolescence risk in the ever changing PC business.
- 3) Concentration on standards-based technologies. Their R&D represents less than 1% sales. The reduced number of suppliers of mainstream components makes easier for them to efficiently manage their supply chain.
-4) Market share growth to preserve a strong bargaining power with their suppliers and spread their fixed costs over a large sale base.

Though their business mix is slowly making progress towards higher margin products and recurring products and services their main strength is basically being the low cost PC provider, delivering a competitive commodity product with an good service level. More on service issues and recent improvements below.


2) ROCK SOLID BALANCE SHEET, STRONG CASH FLOW AND AMAZING PROFITABILITY TRACK RECORD

Despite an historically low 4-6% operating margin investors tended recently to forget that DELL remains an amazingly solid profitable company.

DELL is sitting on a comfortable $ 10.8 Bil. cash and investments cushion. Long term debt is only $ 504 mil. However according to last quarterly conference call management advised that it will have to borrow on short term basis for his corporate/US operations. Cash hoard is increasing abroad where sales are growing a lot more than in USA. To take into account potential tax repatriation costs we will use a conservative
USD 9.0 Bil. excess cash at the end of FY 2008.

Management has always been able to squeeze prodigious amounts of cash flows despite modest operating margins.
They have a negative 44 days cash conversion cycle which means that their sales are converted in hard cash 44 days BEFORE the sale. How it is possible ? Low inventory and strong bargaining power over their suppliers on payment terms. On the other side their clients are paying cash in advance or shortly after delivery of the products.

In a trough margin environment DELL produced in trailing 12 months about $ 4.3 Bil. net free cash flows out of $ 57.4 Bil. sales. Free Cash Flows/Enteprise Value yield is around 9% for the same period.

Profitability for a product/service mix still heavily weighted on a commodity product are truly amazing.

The below figures provided by Reuters are self-explanatory.

Magement Effectiveness (%)	Company	Industry	Sector	S&P 500
Return On Assets (TTM)	12.57	10.35	11.21	8.13
Return On Assets - 5 Yr. Avg.	13.75	5.29	6.27	6.43
Return On Investment (TTM)	40.16	22.77	15.31	12.08
Return on Investment - 5 Yr. Avg.	33.44	12.57	8.91	10.01
Return On Equity (TTM)	68.75	33.13	19.46	20.05
Return On Equity - 5 Yr. Avg.	46.19	16.61	12.03	17.96

3) INDUSTRY TRENDS

PC worldwide industry is highly competitive. Through an aggressive price war this industry is slowly becoming an oligopoly where highly efficient global players put out of business or purchase the weakest PC makers (see sale of IBM PC business to LENOVO) .
Main competitors:
Hewlett-Packard with its more attractive product mix of high margin and recurrent revenues (their printer business) and their streamlined operations are a dangerous competitor. Turnaround leaded by the new CEO Mark Hurd has done a good job so far but he harvested mainly the "cutting costs" low hanging fruits and still heavily depends on H-P crown jewel printing business. Increasing revenues and profits in the next years will be more difficult. I assume recent boardroom scandal: will not have a relevant impact on company operations.

More dangerous, because traditionally less financially disciplined, is the competition of Far East competitors notably ACER and LENOVO. The last is more or less backed by the Chinese Government. It bought formed IBM PC business, and, like ACER, is aggressively pursuing market share gains pointing on price cuts notwithstanding what is believed to be a tiny (if any) real profit margin.
LENOVO is not forced to fill accounting documents according to GAAP rules. But a look at their most recent FY figures ending march 2006 is interesting. They reported the equivalent of $13.3 bil. sales and profit margin atribuable to Shareholders of the Company was the equivalent of about $13.309 mil., net profits (generously adding back restructuring charges and amortization of intangible assets) were the equivalent of about $100 mil. A meager 1.44% net margin profit compared to about 6.8% net margin of DELL during a similar period.

Price competition is expected to last at least few more quarters but, though DELL cost advantage is lower than a few years ago, they are still more efficient then their competitors.


4) CHALLENGES

Main competitors improved their supply chain management and DELL has lost part of its previous cost leadership though due to its direct sale/build-to-order it still avoids retail inventory burden. In order not to loose this critical advantage DELL cannot afford to deviate from its proven "no inventory" business model.

Poor customer service: DELL has finally recognized its weakness. They invested so far more USD 150 mil. Internal and independent customer satisfaction metrics are already improving.
The implementation of DellConnect, their new remote diagnostic tool designed to improve resolution of technical issues for free, has been used by more than 1 mil. customers and seems getting positive reviews by customers.

DELL has troubles to maintain market share in the consumer market.
Foray in flat panel TV, mp3 players has been performing poorly.
Mainstream consumer PC are priced below the USD 500 mark and are still expected to decrease further. The cost advantage at this level gets erased by the extra shipping costs of shipping unit by unit instead of bulk shipping to retail stores.
DELL is performing some tests with retail kiosks used to order PC with the assistance of a sales representative in malls, airports... I don't think that those sales will reach a meaningful amount.
Due to its "no inventory" business model, DELL is unable to match the rewarding experience of bringing back home the computer or printer you've just bought at the store. Management has repeated that they do not intend to develop a classic retail channel.
Only way to compete: investing in design and proposing more cool products, which to be fair are far to be DELL point of strength.
In September DELL added 500 new electrical, software and mechanical engineers and program managers in its central Texas product development operations to improve product quality.
Recent purchase the high-end gamers PC outfit ALIENWARE fits also the bill to improve overall product quality level: However the ALIENWARE $220 mil. yearly sales figures involved are merely a blip in DELL total turnover.

The dark side of DELL, stock options: company made an extremely liberal use of the stock options in the past. The use of capital to re-purchase stocks to avoid share dilution and shrink overall share base has been abysmal. Billions of dollars have been literally thrown out of the window to repurchase company stock which was trading at obscene valuation. On this matter there are however some improvements. Stocks options are now expensed in financial statements and taking into account by the analyst community. Issuance slowed down and in last 10K we calculated that about 80% of the outstanding options are out of money. DELL may re-price these options but they never did it in the past.

For several quarters in a row management advised that they were pricing too aggressively for a modest market share gain. My impression is that margin have been reduced due to lack of cheaper and better AMD processors in their products offering. See below.


5) OPPORTUNITIES

These last quarters AMD processors have sported better price and performance than their INTEL rivals. Since DELL was an INTEL-only shop to gain market share they have been forced to compete on price and lower their already thin margins.
Ironically, just when INTEL is proposing a competitive line of new products, DELL started to ship its first AMD powered PCs.
They will loose some support and contribution on marketing expenses from DELL but having the possibility to opportunistically play on both suppliers is in any case a long term positive for DELL.

DFS finance arm: leasing and financing on DELL products is now handled by DFS, a joint venture with CIT. So far this financing was proposed only to match financing offerings from competitors. It represents now a small portion of earnings but it may grow in the future. After learning how to profit from lending business DELL has already in place the agreement which will allow to purchase CIT stake.
Financing may be cash draining if they decide to keep loans on their books and earnings may be hit in cases of default during the trough of business cycle or if DELL has a poor underwriting discipline (which has not been the case sofar). Overall, the finance profits over a full business cycle will be a positive contributor to their structurally low margins. Commodity producers like auto makers GENERAL MOTORS and FORD granted their survival of their main operations and a more than adequate profit margin thanks to their finance arms.

Printers and ink: printer sales are in ramp up phase when they are sold slightly below cost to earn then after a high margin on ink refills. In financial statements you see so far the investments to spread the printers. Then after ink refill margins will start to materialize.

Monetizing desktop real estate: why about 85% of internet users still use Internet Eplorer to surf the web though they are much better free alternatives like Firefox ? Because it's the default preloaded version on their Microsoft PCs and they don't bother to change it. Desktop real estate is therefore worth a lot. In a 3 years deal Google agreed to pay what is rumored to be worth up to $1 Bil. according to Forbes magazine to pre-load Google Desktop Search and Google Toolbar in about 100 mil. PCs. I expect further similar deals with other software houses or websites though most probably worth smaller amounts.

Acquisitions: Michael Dell recently said the company may pursue further "small targeted acquisitions" after its recent purchase of high-end PC company Alienware to provide new services, products and geographic areas. Cash on balance sheet is more than enough to finance acquisitions. Acquisition discipline has not been tested in the past since company focused on organic growth or joint-ventures on storage products, finance arm and printers. Terms of recent Alienware acquisition have not been disclosed. I expect however that due to its cost conscious culture (stock repurchases issue excepted) DELL will not overpay. The ideal acquisition would be one which allows either permanent margin increases in the service area for exemple, and/or introduce some kind of recurrent revenues.

Launching of Vista, the new Microsoft operating system: the long overdue, but much improved compared to last Windows XP, is widely expected among consumers and business users. The first beta versions got positive reviews and first signs points to a strong start (see


6) RECENT ISSUES: LAPTOP RECALL, ACCOUNTING RESTATEMENT, EARNINGS MISS

Laptop recall: same was due to SONY batteries defect. SONY will pay almost all recall expenses. DELL was the most proactive to acknowledge the problem and quickly provided a solution to their customers. In a Barrons' interview Michael pointed out that they bought only 18% of defective batteries. "Where are the others ?" he wondered. In fact one after the other shoes are dropping. Weeks after DELL announcement Apple, Lenovo, Toshiba, Hewlett Packard, Hitachi finally recognized the issue and took proper steps.

Accounting restatement: after an informal SEC investigation which was deemed to be not material DELL has been forced to delay their quarterly 10Q filing and interrupt their share repurchase program. Accounting expert Jack Ciesielki gave his opinion of which misrepresentation may be involved. According to the few elements leaked on the issue, the eventual restatements should not affect company normalized profitability and strong balance sheet figures.

Potential future earnings miss: Think Equity, a research and investing boutique, is on the record warning on a possible earnings miss for current quarter. As a long term value investor, as far as I'm confident on assessment of company business value, earning pre-anouncements and their consequent investor over-reaction are not an issue but an opportunity to buy on the cheap.


7) MACRO ECONOMIC RISKS

This last decade both emerging and developed countries has been growing at a fast clip with the major notable exception of the Eurozone countries. Japan which arrived late at the growth party is joining the ranks. Corporations have records of cash and ready to invest it also in technology products. Interests are low and inflation is moderate. This almost ideal environment may become less accommodating in the next years especially if the U.S. or the white-hot China economies will slow down.


8) VALUATION

I evaluate DELL business value at 15 x FY 2008 earnings (less estimated $9 Bil. excess cash) based on average 7% sales growth and a normalized 7.5% operating margin. Reasonable valuation would be therefore in the area of $21/21.5 per share.
Stock is sitting about 8% less than present quote at $23.25 on Friday Oct. 6 close.

The most aggressive value investors may want to start a position alongside the founder Michael Dell which made one of the biggest insider purchase in open market ever in U.S. stock market. He bought $70 mil. worth shares on May 24th 2006 at $23.99.