Fitch: Jefferies' 3Q16 Trading Results Stable; Capital Markets Remain Challenging
Results of this nature are incorporated in Jefferies ratings of 'BBB-'/'F3' and Stable Rating Outlook, as Fitch expects quarterly earnings volatility given the cyclical nature of Jefferies business model. Overall, ratings continue to be supported by the company's maintenance of conservative balance sheet positioning, capital levels commensurate with the rating category, and what Fitch views as moderate risk levels.
Jefferies' quarterly net revenues of $654 million were down 9.0% from $719 million in 2Q16 but up 13.1% from the year prior. Equities sales and trading revenues were $148.3 million (down from $223.5 million in 2Q16), the difference reflecting minimal mark to market gains of $2 million on Jefferies' two largest equity positions (one of which was disclosed as being KCG Holdings Inc.), compared to $60 million and $66 million of mark to market gains in the second quarter and the year ago quarter, respectively.
Fixed income quarterly revenues declined to $195.3 million from $238.5 million the prior quarter but rebounded compared to the prior year's third quarter loss of $18.2 million. Lower quarter-on-quarter revenue was likely impacted by lower trading volumes ahead of the 'Brexit' referendum. In Fitch's view, improved year-on-year performance highlights Jefferies' efforts to restructure its fixed income businesses to operate more efficiently and with higher levels of lower risk liquid assets.
Investment banking net revenues increased to $295 million, up 17% on a linked-quarter basis and down 24% compared to the prior year. Advisory revenues were steady year-on-year but as noted capital markets revenues remained subdued, with continued slow activity in new equity issuance as well as leveraged finance issuance. Equity capital markets performance is highly sensitive to IPO activity, much of which has been delayed due to ongoing economic and political uncertainty. Jefferies reported that its fourth quarter investment banking backlog is at its highest level this year, which would boost advisory and capital markets results to the extent that market uncertainty abates and transactions are closed.
Total non-interest expense declined 7% quarter-on-quarter, commensurate with the decline in net revenues and driven primarily by lower compensation expense, leading to quarterly earnings before taxes of $80.7 million. This represented a 21% decline from the previous quarter but a significantly increase from the prior year period, which included losses in its fixed income businesses.
In 3Q16, Jefferies' risk and capital positioning remained relatively unchanged. The balance sheet increased slightly to $38.1 billion from $37.1 billion a quarter prior, driven by an increase in cash, but remained well below $42.8 billion from the year ago period. Jefferies' reported firm-wide VaR for the quarter was $6.62 million, down 20% from the prior quarter and down 52% compared to 3Q15, driven by both a reduction in risk, as well as lower overall market volatility.
Jefferies-calculated adjusted leverage, defined as assets excluding securities borrowed, reverse repurchase agreements, cash and goodwill, and intangibles divided by tangible equity, was estimated at 8.8x at Aug. 31, 2016, down from 9.0x at May 31, 2016. Fitch views Jefferies' balance sheet, leverage and VaR levels as commensurate with the rating category, although it is expected that over time Jefferies may modestly redeploy capital and increase its risk appetite.
Jefferies-calculated liquidity, which includes cash, cash equivalents, high-quality government securities and reverse repurchase agreements collateralized by high-quality government securities, remained solid at 13.8% of total tangible assets at 3Q16 (up from 13.1% of total tangible assets at 2Q16). Jefferies continued to maintain ample cash-on-hand, measuring $3.2 billion as of Aug. 31, 2016, representing 8.3% of total assets up from $2.8 billion as of May 31, 2016, representing 7.6% of total assets.
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, 2016, Jefferies had U. S. GAAP total assets of $38.1 billion and shareholders' equity of $5.3 billion (including non-controlling interests and $1.9 billion of goodwill and intangibles). 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.