Jefferies Financial Group - 10-Q quarterly report FY2010 Q3

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YES               X                                NO           _____

 

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See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

 

PART I – FINANCIAL INFORMATION

Item 1.  Financial Statements.

Consolidated Balance Sheets

Consolidated Statements of Operations

(continued)

Consolidated Statements of Operations (continued)

Consolidated Statements of Cash Flows

 

(continued)

Consolidated Statements of Cash Flows (continued)

 

Consolidated Statements of Changes in Equity

 

The unaudited interim consolidated financial statements, which reflect all adjustments (consisting of normal recurring items or items discussed herein) that management believes necessary to fairly state results of interim operations, should be read in conjunction with the Notes to Consolidated Financial Statements (including the Summary of Significant Accounting Policies) included in the Company’s audited consolidated financial statements for the year ended December 31, 2009, which are included in the Company’s Annual Report filed on Form 10-K for such year (the “2009 10-K”).  Results of operations for interim periods are not necessarily indicative of annual results of operations.  The consolidated balance sheet at December 31, 2009 was extracted from the audited annual financial statement s and does not include all disclosures required by accounting principles generally accepted in the United States of America (“GAAP”) for annual financial statements.

Effective January 1, 2010, the Company adopted new Financial Accounting Standards Board guidance for the accounting for transfers of financial assets, and guidance for the accounting and reporting of variable interest entities.  This adoption did not have any impact on the Company’s consolidated financial statements.

Certain amounts for prior periods have been reclassified to be consistent with the 2010 presentation, and to reflect as discontinued operations ResortQuest International, LLC (“ResortQuest”), STi Prepaid, LLC (“STi Prepaid”) and the Company’s power production business.  For more information, see Note 15.

The primary measure of segment operating results and profitability used by the Company is income (loss) from continuing operations before income taxes.  As a result of the classification of ResortQuest and STi Prepaid as discontinued operations, the Company no longer has a property management and services segment or a telecommunications segment.  The Company’s power production business, which was also classified as a discontinued operation, was previously included in the other operations segment.  Associated Companies are not considered to be a reportable segment, but are reflected in the table below under income (loss) before income taxes.  Certain information concerning the Company’s segments for the three month and nine month periods ended September 30, 2010 and 2009 is presented in the following table.

For the three and nine month periods ended September 30, 2010 and 2009, segment operating results include depreciation and amortization expenses as follows:

For the three and nine month periods ended September 30, 2010 and 2009, interest expense was primarily comprised of Corporate; interest expense for other segments was not material.

On October 1, 2010, the Company sold all of its ACF common shares to a subsidiary of General Motors Company (“General Motors”), in connection with General Motors’ acquisition of all of the outstanding common stock of ACF.  The Company received aggregate cash consideration of $830,600,000 for its shares of ACF common stock, which were acquired at a cost of $425,800,000.  As of September 30, 2010, the Company had recorded a cumulative net unrealized gain on its investment in ACF in its consolidated statements of operations of $403,400,000.  As a result of the consummation of this transaction, the Company will record in the fourth quarter an additional gain on its investment in ACF of $1,400,000.  Income related to associated companies includes unrealized gains resulting from chan ges in the fair value of ACF of $211,500,000 and $73,300,000 for the three month periods ended September 30, 2010 and 2009, respectively, and $182,200,000 and $268,300,000 for the nine month periods ended September 30, 2010 and 2009, respectively.

As of September 30, 2010, the Company owns approximately 28% of the outstanding voting securities of Jefferies, a company listed on the NYSE (Symbol: JEF).  Jefferies is a full-service global investment bank and institutional securities firm serving companies and their investors.  Income related to associated companies includes unrealized gains (losses) resulting from changes in the fair value of Jefferies of $78,200,000 and $286,700,000 for the three month periods ended September 30, 2010 and 2009, respectively, and $(50,500,000) and $639,900,000 for the nine month periods ended September 30, 2010 and 2009, respectively.

In accordance with GAAP, the Company is allowed to choose, at specified election dates, to measure many financial instruments and certain other items at fair value (the “fair value option”) that would not otherwise be required to be measured at fair value.  If the fair value option is elected for a particular financial instrument or other item, the Company is required to report unrealized gains and losses on those items in earnings.  The Company’s investments in ACF and Jefferies are the only eligible items for which the fair value option was elected, commencing on the date the investments became subject to the equity method of accounting.  If these investments were accounted for under the equity method, the Company would have to record its share of their results of operations employing a quarterly reporting lag because of the investees’ public reporting requirements.  In addition, electing the fair value option eliminates some of the uncertainty involved with impairment considerations, since quoted market prices for these investments provides a readily determinable fair value at each balance sheet date.  The Company’s investment in HomeFed is the only other investment in an associated company that is also a publicly traded company but for which the Company did not elect the fair value option.  HomeFed’s common stock is not listed on any stock exchange, and price information for the common stock is not regularly quoted on any automated quotation system.  It is traded in the over-the-counter market with high and low bid prices published by the National Association of Securities Dealers OTC Bulletin Board Service; however, trading volume is minimal.  For these reasons the Company did not elect the fair value option for HomeFe d.

The following tables provide summarized data with respect to significant investments in associated companies for the periods the investments were owned by the Company.  The information is provided for those investments whose current relative significance to the Company could result in the Company including separate audited financial statements for such investments in its Annual Report on Form 10-K for the year ended December 31, 2010 (in thousands).  The 2010 information for ACF is for the six month period ended June 30, 2010, which is the latest available information.  The 2010 information for Jefferies is for the eight month period ended August 31, 2010.

During 2007, the Company and Jefferies formed JHYH and each initially committed to invest $600,000,000.  The Company invested $250,000,000 in cash plus its $100,000,000 investment in Jefferies Partners Opportunity Fund II, LLC during 2007; any request for additional capital contributions from the Company requires the consent of the Company’s designees to the Jefferies board.  The Company does not anticipate making additional capital contributions in the near future.  Through its wholly-owned subsidiary, JHYH makes markets in high yield and special situation securities and provides research coverage on these types of securities.  Jefferies and the Company each have the right to nominate two of a total of four directors to JHYH’s board, and each own 50% of the voting securities. & #160;The organizational documents also permit passive investors to invest up to $800,000,000.  Jefferies also received additional JHYH securities entitling it to 20% of the profits.  The voting and non-voting interests are entitled to a pro rata share of the profits of JHYH, and are mandatorily redeemable in 2013, with an option to extend up to three additional one-year periods.  Under GAAP, JHYH is considered a variable interest entity that is consolidated by Jefferies, since Jefferies is the primary beneficiary.  The Company owns less than 50% of JHYH’s capital, including its indirect interest through its investment in Jefferies.  The Company has not provided any guarantees, nor is it contingently liable for any of JHYH’s liabilities, all of which are non-recourse to the Company.  The Company’s maximum exposure to loss as a result of its investment in JHYH is limited to the book value of its investment plus any additional capital it decides to invest.

During the third quarter of 2010, the Company redeemed its interest in Pershing Square by transferring its equity into a larger, more diversified investment partnership fund managed by the same manager.  The Company’s percentage ownership interest in this larger investment partnership is much smaller and does not qualify for the equity method of accounting.

The amortized cost, gross unrealized gains and losses and estimated fair value of available for sale investments classified as current assets at September 30, 2010 and December 31, 2009 are as follows (in thousands):

A summary of non-current investments at September 30, 2010 and December 31, 2009 is as follows (in thousands):

Non-current available for sale investments include 5,600,000 common shares of Inmet Mining Corporation (“Inmet”), a Canadian-based global mining company traded on the Toronto Stock Exchange (Symbol: IMN), which have a cost of $78,000,000 and market values of $311,900,000 and $339,100,000 at September 30, 2010 and December 31, 2009, respectively.  The Inmet shares have registration rights and may be sold without restriction in accordance with applicable securities laws.

The Company’s investment in Fortescue and its subsidiary, FMG Chichester Pty Ltd (“FMG”), consists of 247,986,000 common shares of Fortescue, representing approximately 8% of the outstanding Fortescue common stock at September 30, 2010, and a $100,000,000 note of FMG that matures in August 2019 (the “FMG Note”).  Fortescue is a publicly traded company listed on the Australian Stock Exchange (Symbol: FMG), and the shares held by the Company may be sold without restriction on the Australian Stock Exchange or in accordance with applicable securities laws.  The Fortescue shares, which are included in non-current available for sale investments, have a cost of $219,700,000 and $246,300,000 and market values of $1,249,500,000 and $1,108,000,000 at September 30, 2010 and December 31, 2009, r espectively.  In February 2010, the Company sold 30,000,000 common shares of Fortescue for net cash proceeds of $121,500,000, which resulted in the recognition of a net securities gain of $94,900,000 in the nine month period ended September 30, 2010.

Interest on the FMG Note is calculated as 4% of the revenue, net of government royalties, invoiced from the iron ore produced from the project’s Cloud Break and Christmas Creek areas.  The note is unsecured and subordinate to the project’s senior secured debt.  Interest is payable semi-annually within 30 days of June 30th and December 31st of each year; however, cash interest payments on the note have previously been deferred by FMG due to covenants contained in the project’s senior secured debt (for periods prior to January 1, 2010).  Any interest payment that was deferred earned simple interest at an annual rate of 9.5%.  160;Inasmuch as the senior secured debt has been called for redemption on November 8, 2010, the covenants requiring the deferral of interest should no longer apply.  The Company recorded interest on the note of $36,100,000 and $19,700,000 for the three month periods ended September 30, 2010 and 2009, respectively, and $104,400,000 and $50,200,000 for the nine month periods ended September 30, 2010 and 2009, respectively.  In the third quarter of 2010, the Company received $172,100,000 (before withholding taxes) from FMG in payment of the accrued interest due through June 30, 2010.  At September 30, 2010 and December 31, 2009, the accrued interest receivable balance was $38,800,000 and $106,500,000, respectively.

For accounting purposes, the Company allocated its initial Fortescue investment to the common shares acquired (based on the market value at acquisition), a 13 year zero-coupon note and a prepaid mining interest.  The Company is accounting for the zero-coupon note component of its investment as a loan-like instrument, with income being recognized as the note is accreted up to its face value of $100,000,000.  At September 30, 2010 and December 31, 2009, the zero coupon note had a balance of $35,200,000 and $32,200,000, respectively.  The prepaid mining interest was initially classified with other non-current assets and is being amortized to expense as the 4% of revenue is earned.  Depreciation and amortization expense includes prepaid mining interest amortization of $2,500,000 and $2,400,000 for the three month periods ended September 30, 2010 and 2009, respectively, and $7,400,000 and $5,000,000 for the nine month periods ended September 30, 2010 and 2009, respectively; the prepaid mining interest balance was $166,800,000 and $174,300,000 at September 30, 2010 and December 31, 2009, respectively.

The aggregate book values of the various components of the FMG Note, net of accrued withholding taxes on interest, totaled $230,300,000 and $302,400,000 at September 30, 2010 and December 31, 2009, respectively.

On August 9, 2010, the Company was advised that Fortescue is asserting that FMG is entitled to issue additional subordinated notes identical to the FMG Note in an unlimited amount.  Fortescue further claims that any interest to be paid on additional subordinated notes can dilute, on a pro rata basis, the Company’s entitlement to the above stated interest of 4% of net revenue.  This claim was made four years after the issuance to the Company of the FMG Note, during which time Fortescue has never asserted this purported right to dilute the Company’s interest in any of Fortescue’s public filings or other communications.   The Company does not believe that FMG has the right to issue additional notes which affect the Company’s interest or that the interpretation by Fortescue of the term s of the FMG Note, as currently claimed by Fortescue, reflects the agreement between the parties.

On September 1, 2010, the Company filed a Writ of Summons against Fortescue, FMG and Fortescue’s Chief Executive Officer in the Supreme Court of Western Australia.  The Writ of Summons seeks, among other things, an injunction restraining the issuance of any additional notes identical to the FMG Note and damages.  If the litigation is ultimately determined adversely to the Company and additional notes are issued, the Company’s future cash flows from the FMG Note and future results of operations would be materially and adversely affected to the extent of the dilution resulting from the issuance of such additional notes.  

During 2010, a Minerals Resource Rent Tax was proposed in Australia that would impact Fortescue if enacted by the Australian legislature; the proposed effective date of the tax is July 1, 2012.  Meetings between Australian government officials and mining companies in Australia are ongoing, and the initial proposal has changed and remains subject to further change.  However, as currently proposed the tax will not have any impact on the calculation of the interest payable on the FMG Note, although when it was first proposed the extra tax burden did have an adverse impact on the value of the Fortescue common shares held by the Company.  Further, based on the Company’s review of available information concerning the proposed tax and its anticipated impact on Fortescue, the Company does not believe the current proposed tax is so onerous as to cause a liquidity problem for FMG resulting in FMG’s inability to service its debt obligations, including the FMG Note.  The Company does not believe that its zero-coupon note or prepaid mining interest are impaired or will become impaired as a result of the proposed tax.

 

At September 30, 2010 and December 31, 2009, other non-current investments include investments in private equity funds where the Company’s voting interest isn’t large enough to apply the equity method of accounting ($87,900,000 and $52,800,000, respectively), a portfolio of non-agency mortgage backed bond securitizations where the underlying assets are various individual mortgage loans ($3,900,000 and $14,000,000, respectively), the FMG zero-coupon note component of the FMG Note discussed above, a stock interest in LPH, the electric utility in Barbados, ($18,800,000 at December 31, 2009), an investment in IFIS Limited (“IFIS”), a private Argentine company, ($11,200,000 in both periods) and various other non-publicly traded interests in equity and debt securities ($29,500,000 and $35,000,000, respectively).  ; The investments in bond securitizations are acquisitions of impaired loans, generally at a significant discount to face amounts.  The Company estimates the future cash flows for the securitization interests to determine the accretable yield; increases in estimated cash flows are accounted for as a yield adjustment on a prospective basis but decreases in estimated cash flows below amortized cost are recognized as impairments.  Contractual cash flows in excess of estimated cash flows are not part of the accretable yield.  The market for these securities is highly illiquid and they rarely trade.  On a regular basis the Company re-estimates future cash flows and records impairment charges if appropriate.  The remaining other investments are accounted for under the cost method of accounting, reduced for impairment charges when appropriate.

In May 2010, the Company sold its investment in LPH for cash consideration of $85,000,000, which resulted in the recognition of a net securities gain of $66,200,000 in the nine month period ended September 30, 2010.

The amortized cost, gross unrealized gains and losses and estimated fair value of non-current investments classified as available for sale at September 30, 2010 and December 31, 2009 are as follows (in thousands):