UPDATE 2-Jefferies shares drop sharply on weak operating results
* Adjusted eps 32 cents vs. Street view 29 cents
* Knight stake boosts earnings by 8 cents/share
* Jefferies shares fall 6.6 percent to $14.62 after report
* Analysts question plans for pay, funding and potential downgrade
Sept 20 (Reuters) - Jefferies Group Inc, an investment bank, reported quarterly banking and trading revenue below some analysts' forecasts, a sign that the summer was likely also rough for its bigger competitors, and the bank's shares fell 6.6 percent.
Trading activity picked up across the board in September thanks to fresh stimulus plans from the U.S. Federal Reserve, the bank's chief executive said. But a better September was too late to help Jefferies' fiscal third-quarter results, which cover the three months ended Aug. 31.
The New York-based bank reported a 2.8 percent rise in third-quarter profit on Thursday, but excluding the acquisition of a stake in Knight Capital Group Inc, results came in slightly below what some analysts had been expecting.
JMP Securities analyst David Trone cut his estimates and price target for the firm, saying Jefferies' operating results excluding the Knight revenue and other special items "fell short" and that he expected the stock to "remain captive" to broader economic concerns.
Trading volumes and investment banking deals were stagnant in the quarter. Because the firm reports earlier than bigger Wall Street competitors, whose quarter ends Sept. 30, investors tend to look at Jefferies' results as a harbinger for what will come from banks like Goldman Sachs Group Inc and Morgan Stanley.
Chief Executive Richard Handler said conditions have improved dramatically this month after the U.S. Federal Reserve unveiled a program to purchase $40 billion in mortgage bonds.
"September has begun extremely well," Handler said on a conference call with analysts, citing improvements "literally across the board" in fixed-income and equities trading globally.
But while improvements from the Fed's stimulus program, or QE3, will undoubtedly help bank profits in the short term, banking analyst Meredith Whitney questioned whether the temporary improvements are just delaying resolution of fundamental issues hampering industry profits since 2010.
"QE3 makes everybody feel like a really smart trader," she said on the Jefferies conference call.
Analysts hammered Jefferies with questions about some of those issues on the call, asking about the high portion of its revenue that goes toward compensation, about how the bank funds itself, and about how the threat of a Moody's downgrade may affect the company in terms of business and collateral calls.
Jefferies paid employees 59.6 percent of net revenue last quarter, in line with previous periods but higher than the 50 percent ratio that industry peers generally target. Three analysts asked management about the figure, and how they expect it to change moving forward.
Handler said he expects the payout ratio to decline naturally over the next two years or so as revenues rise with better market conditions, as employees become more productive, and as retention bonuses, promised to woo talent in recent years, wind down.
"We have obviously a long way to go from where we are to where we need to get," he said.
Jefferies executives also said a potential Moody's downgrade would not have a significant effect on their trading business because Jefferies does not have much exposure to over-the-counter derivatives, the kind of trades that would likely be subject to large collateral calls if a downgrade occurred.
Moody's, which already downgraded 15 other banks with large capital markets businesses this year, said this month that it may cut Jefferies' rating as well.
Jefferies' results were muddied by the Knight stake and by special items related to its acquisitions of Hoare Govett and Bache. The company acquired the Knight stake last month when it took part in a private bailout of the market-making firm after Knight suffered a $440 million trading loss due to a software glitch.
Jefferies posted earnings of $70.2 million, or 31 cents per share, for its fiscal third quarter, up 2.8 percent from $68.3 million, or 30 cents per share, a year earlier.
Adjusted earnings were 32 cents per share, topping analysts' average estimate by 3 cents, according to Thomson Reuters I/B/E/S. But excluding the Knight revenue, Jefferies' results missed some analysts' estimates by a wide margin.
Trone estimated that the firm's operating earnings were just 24 cents per share and Oppenheimer analyst Chris Kotowski said the reported figure came in 10 cents below his estimate, which included Knight.
Jefferies said its stake in Knight contributed 8 cents to its earnings per share, and $103.3 million to principal transactions revenue.
Jefferies' overall revenue rose 45.1 percent, largely due to positive income in principal transactions, versus a loss in that trading business a year ago.
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