Sunday, September 6, 2009

Update: a controversial choice

If you are a first timer, please read the following pieces first. It will provide you with important background information.
1. Why I created this blog?
2. How am I going to operate this blog?

I bought 200 shares Leucadia National Corp (LUK) at $23.45 on September 3, 2009. I paid additional $4.95 for this transaction. During this downturn and previous Katrina disaster, I have bought BRK.B, BAM and L that have business models similar to LUK. I still have others on my watch list. In its 2008 annual report, LUK summarized its business model:

"We tend to be buyers of assets and companies that are troubled or out of favor and as a result are selling substantially below the values, which we believe, are there. From time to time, we sell parts of these operations when prices available in the market reach what we believe to be advantageous levels. While we are not perfect in executing this strategy, we are proud of our long-term track record. We are not income statement driven and do not run your company with an undue emphasis on either quarterly or annual earnings. We believe we are conservative in our accounting practices and policies and that our balance sheet is conservatively stated."

As management suggested above, I believe book value is the best proxy of LUK's intrinsic value. From its 2nd quarter 10Q, I easily calculated its GAAP book value per share to be $14.86. I am paying almost 60% premium on its book value. I don't believe, its management, brilliant as it is, deserves such a huge premium. It is in the hidden assets not showing up in their balance sheet. First, it has a Tax Loss Carryforwards of about $5B meaning if it has earnings of $5B, it doesn't need to pay the tax on the $5B. It perhaps worth $1.8B if LUK can generate earning of $5B in 2009. Of course, LUK can't, at least not in 2009. Therefore, the current value of this asset is perhaps only $1B. That brings its adjusted book value to $18.89. I would certainly not buy it at 25% premium on its book unless, yes, unless, I thought its book value was still way understated.

Second, let's look at its public listed holdings. IMN rose 25.47% since June 30, FMG rose 12.13%, JEF rose 5.8%, ACF rose 20.75% and HOFD rose 17.95%. Just for the securities listed above, I can raise the current book value per share to $19.95. It is harder to estimate its non-listed investments. If I believe they rose similar to the public listed investments, LUK's book value is close to $21. Furthermore, LUK usually picks up assets from the corporate junkyard. While those assets being fixed, they won't produce positive cash flow. But once they are fixed and sold, usually they generate big gains. The management has done this many times. I believe its operating business is also understated in its balance sheet. I don't know how much though. Anyway, I am not paying a big premium over LUK's adjusted book.

LUK is a controversial stock. But even the critique hinges on its book value. It is highly exposed to real estate and resources. From its most recent proxy statement, Cummings and Steinberg jointly own close to 23%. Its management's interest aligns nicely with shareholders'. Another prominent investor, Bruce Berkowitz and the organization he controls, own 7.5%. By the way, Bruce commented that he was a buyer when LUK was in 30's. Another big institution, Morgan Stanley owns a big block. Therefore, about 40% is owned by insiders or management friendly big institutions. You have to wonder where all the sell pressure comes from.

Among its peers with similar business model, BRK.B and L can use float (unpaid insurance premium) with close to 0 cost. That is a huge advantage. BAM and LUK have to access the capital market from time to time. LUK financed its portfolio through high yield debt. The positive is that the earliest maturity of which is in 2013. But LUK is way smaller. Its manager, poorer and therefore, hungrier and meaner. It made a couple of mistakes recently including relying on others to do the heavy lifting. But now, with networth halved, I guess Cummings and Steinberg will work harder for themselves and for me. Recently, LUK worked with BRK.B bought Capmark out of bankruptcy. I hope this is the good omen for a glorious new start.

“Fortress Leucadia” is the management's draconian look into the future and a basis for defensive planning. It assumes LUK will not make any more investments, continue watching its expenses, keep only assets that are promising and slowly turn everything into cash which will be used first to retire or pay down debt, while always maintaining at least $500 million in cash or liquid assets. Management acknowledged that in the current recessionary environment, earnings from its operating businesses and investments do not presently cover its overhead and interest. But it believes LUK has cash, liquid investments and securities and other assets that it expects to turn into cash that should carry it through these difficult times. And I believe LUK's management.

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