Will Jefferies Survive the Economic Downturn?

Traders as well as longer term investors are continually nervous about Jefferies JEF, the largest independent investment bank in the US. With rumors of massive job cuts, the stock has been tumbling downwards, and investors are wondering if it is a failure in progress or a major buying opportunity.

In November, rumors started to surface that Jefferies may be exposed to Europe in an extremely unfavorable way. The rumors themselves sent the stock spiraling downward, and Jefferies immediately took action by disclosing its European debt exposure. The bank ended up being net short by about $9 million.

More recently, investors have been hearing rumors that the company may be cutting jobs in its equities sales and trading division. While downsizing is always occurring throughout Wall Street firms, investors are anticipating major job cuts, which may result in 11% of the firm's entire headcount to be fired. Keep in mind, this figure is related to the entire firm but only affects the equities division.

Investors should be wary of this figure, as this type of downsizing seems to be too abrupt. If the equities desks were so unprofitable that the majority of it had to be cut, cuts would have started a long time ago. Investment banks are not stupid and typically have little patience for unprofitable franchises. Jefferies would have likely started to downsize equities a long time ago if it were losing significant sums of money.

Investors should also keep in mind that Jefferies' primary business is investment banking, not proprietary trading, flow trading, market making, equity research, or investment management. Approximately 17% of its business is comprised of traditional investment bankers, who advise companies on capital raises, mergers and acquisitions, and financial restructurings. If the equities division was unprofitable over the last few quarters, it appears likely that the costs saved by cutting it would help bolster the company's balance sheet. It would also result in a lowered risk exposure to unfavorable trading conditions.

Jefferies is a strong investment banking franchise that continues to grow its primary business while many other banks are downsizing investment banking practices. Investors need to keep the big picture in mind and realize that certain restructuring practices may actually be positive for firms. Furthermore, the rumors have not even been confirmed. Investors should also keep up with the news to stay on top of major developments that move markets.

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ACTION ITEMS:

Bullish View:
Traders who believe that Jefferies is in a better position, contrary to popular belief, might want to consider the following trades:

• Long Jefferies by purchasing shares or call options. Jefferies currently appears to be oversold and close to a technical support level, so now may be a good time to buy.

• Short another similar company, like Piper Jaffray PJC. You could short this company to hedge a long JEF trade or to accentuate your belief that Jefferies will continue to dominate middle market financial services.

• Long an ETF like the Financial Services SPDR XLF. If a significant industry like middle market investment banking is doing well, financial services itself will probably do well.

Bearish View:
Traders who believe that traders are correct about Jefferies' troubles may consider the following positions:

• Short Jefferies until it reaches $11, which is the next, lower technical support level. The next support level appears to be at about $10.

• Long a competitor like Lazard LAZ, as someone bearish on Jefferies may believe that a large-cap competitor is more likely to garner market share.

• Buy put options as Jefferies' earnings announcement comes along. The company may not be able to sustain its costs as European exposure could have brought earnings down further than normal in Q3 2011.

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