Jefferies Financial: Trimming Our Fair Value Estimate Due to First Brands Exposure

Key Morningstar Metrics for Jefferies Financial Group

• Fair Value Estimate: $47.00
• Morningstar Rating: ★★
• Morningstar Economic Moat Rating: None
• Morningstar Uncertainty Rating: High

Jefferies Financial Group JEF shares have fallen 8% over the past week as the extent of its exposure to bankrupt First Brands, a Michigan-based auto parts supplier, has become clearer. The firm has $161 million in direct exposure through its Point Bonita Capital fund and Apex Credit Partners joint venture.

Why it matters: While the magnitude of Jefferies’ capital exposure is relatively small, the episode could result in more significant litigation, regulatory, or reputational costs.

• Jefferies maintained a long relationship with First Brands—investing in its bonds through Apex Credit Partners, buying its accounts receivable (a practice called factoring) through its Point Bonita Capital fund, and earning investment banking fees for helping to underwrite and distribute the firm’s debt.
• With reputable outlets like the Financial Times citing concerns about receivables being factored multiple times, investors should be aware of likely exposures for the bank.

The bottom line: We peg the probability-weighted impact of direct financial losses, litigation, and regulatory fines at $173 million, a roughly 1.7% haircut to our $49 fair value estimate for the no-moat investment bank, all else equal. Further, we believe the secondary impact of the reputational hit will manifest in weaker asset management flows, leading us to trim our fair value estimate to $47 per share.

• Losses on debt secured by inventory or receivables are historically very low, generally less than 10%, but increase dramatically in the presence of misrepresentation or fraud. Subordinated claims yield an average of just 47% recoveries, per S&P Global, which appears to be the most likely outcome.
• Regarding litigation exposure and regulatory fines, we estimate exposure based on prior (non-RMBS) penalties levied on investment banks at about 1.4% of global revenue. Still, the fallout is contingent on both recovery rates and any failures of due diligence by Jefferies that may emerge from the current probe.