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Dec 19 - Jefferies Group Inc. (Jefferies) today reported higher core earnings (excluding extraordinary items) than the prior quarter and significantly better than the challenging fourth quarter of 2011 (4Q'11). Results were driven by improved volumes in both fixed income and equities trading, with fixed income being the larger driver, as equity volumes remain weak relative to historical levels. Activity in the high-yield market has helped sustain the firm's momentum in the fixed income business over the last four quarters. These results are consistent with Fitch's expectations and are considered to be credit neutral.
Full-year core net revenues were up 12% year-over-year and surpassed prior periods, while core net income was down approximately 10% (both measures exclude recent gains from Knight Capital Group ). Margins were lower in 2012, primarily due to an increase in compensation expense, as Jefferies added to headcount and maintained a slightly higher compensation ratio. Fitch would expect the compensation ratio to trend back down as recent hires achieve run-rate revenue production and the amortization of certain compensation expenses from recent acquisitions runs off.
Jefferies' 4Q'12 results were supported by debt capital markets (DCM) revenues, which were up 66% from the linked quarter and 18% year-over-year. While DCM revenues have been fairly volatile over the past several quarters, they generally continue to trend higher as improving market conditions have led to improved volumes.
Despite the improvement in the capital markets business, overall investment banking revenues were up by a more modest 9%. This was primarily the result of weak advisory fees, which were at the lowest level since 2Q'10. Mergers and acquisitions (M&A) activity remains sluggish as many clients are averse to the uncertain macroeconomic and market conditions.
Jefferies' opportunistic investment in Knight boosted fourth-quarter net income, but to a lesser extent than in the prior quarter. The unrealized gain added approximately $50 million to the reported equities trading revenue and represented $7 million of the $72 million in net income for the quarter. Reported earnings for the past two quarters include approximately $26 million of mark-to-market gains from the company's investment in Knight, which Fitch views as non-recurring.
Value at Risk (VaR) continues to be elevated as a result of its position in Knight, and comprised approximately 37% of the firm-wide average VaR during the fourth quarter. Jefferies continues to be Knight's largest shareholder, with an ownership stake of approximately 44%. VaR is likely to remain elevated until Jefferies reduces its investment in Knight, which Fitch views as relatively large and opportunistic.
The balance sheet increased modestly during the fourth quarter while leverage stayed roughly the same, close to historically low levels. Fitch-calculated leverage has ranged between 9x and 10x over the last four quarters. Fitch expects that over time, as market conditions stabilize, the firm may manage its leverage modestly higher. Jefferies continues to maintain a solid liquidity buffer, with over $4 billion in cash and unencumbered collateral.
Jefferies' ratings were placed on Rating Watch Negative on Nov. 12, 2012 in connection with the company's planned merger with Leucadia National Corp. Market reaction to the transaction has been positive with most of the firm's bonds trading up since the announcement. For more information, please see the press release titled 'Fitch Places Jefferies' 'BBB' L-T IDR on Rating Watch Negative on Proposed Merger with Leucadia,' available at www.fitchratings.com.'
Jefferies, a Delaware-incorporated holding company, is a well-established full-service investment bank and institutional securities firm primarily serving middle-market clients and investors. Its primary broker/dealer operating subsidiary, Jefferies & Company, Inc., holds the vast majority of the firm's consolidated assets and is regulated by the SEC. At Nov. 30, 2012, Jefferies had U.S. GAAP total assets of $36.3 billion and shareholders' equity of $3.4 billion (including non-controlling interests).