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Fairfax Q1 10 Earnings


Viking
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Here is my edited post from Dec 15th (stock value update is attached). Q1 increase in BV = $15/share; take out $10 dividend and March 31 BV = $375/share. Analysts are expecting earnings of $6.00 (last year was -$3.55) so ‘optics’ should be good (i.e. they should be able to beat). I expect FFH to have realized some of their equity gains. In the near term the key catalyst for a pop in the share price would be if FFH aggressively buys back shares (not likely until after the Zenith purchase). The risks to the down side include the insurance soft market getting worse or a sell off in risk assets.

 

For 2010 I think it reasonable to assume FFH will increase BV by $20/share ($30 including Q1 dividend) with Dec 31 ’10 BV = $390. With shares trading today at US$373.24 the company is cheap but not crazy cheap.

 

Here is my very rough calculation of what FFH should earn in Q1:

1.) Underwriting income (CR = 102) = - $25 mill

2.) Int / Div Income (Q4 $172.4) = $175

Operating Income = $150

3.) Net Gains on Invest = $350 (incl unrealized gains)

4.) Interest Exp = $50

5.) Corporate Overhead = $25

Pre Tax Income = $425

6.) Inc Taxes (28%) = $305

Increase in Bv = $306 = $15/share

 

Q4 BV = $369.80

BV Growth = 4%

 

Assumptions

- CR = 102. Soft market continues; Q1 saw significant cat activity.

- stocks were up $400 million in Q1 (this is 30% hedged); hard to know what was sold. I expect muni bonds to have been flat and corporates and alternative stuff to be up.

- insurance hard market? Looks like it will not be happening soon (still to much capacity). When this happens this could really juice FFH BV growth.

- Q2 will see the close on the Zenith acquisition which will help grow the top line going forward.

- one catalyst for FFH continues to be possibility of share buybacks. FFH has been quite predictable so far in what they are doing with their excess cash (bought NB, ORH & ZNT). I think the next big move will be share buybacks, assuming earnings stay reasonably strong and shares trade at or below book value. The only question is when do they start?

 

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Nnejad, my estimate is simply a starting point to get the discussion going. The only number I am clear on is the interest and dividend number. Yes, realized and unrealized gains have the potential to be much higher than my number. I also view underwriting income as a risk. Put it all together and I would not be surprised to actual results reported by FFH tobe higher.

 

I am hoping that were people have better visibility (i.e. Brick) they let us know and help sketch a more complete picture. Thanks for sharing!

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For 2010 I think it reasonable to assume FFH will increase BV by $20/share ($30 including Q1 dividend) with Dec 31 ’10 BV = $390. With shares trading today at US$373.24 the company is cheap but not crazy cheap.

 

 

$30?  That would be like 8-9% ROE.  I am guessing that their cost of capital is higher than 8-9%.  If that is true, than their fair value would be below book value.

 

I would hope normalized earnings potential would be more like $40-$50 per share at this point.

 

 

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$30?  That would be like 8-9% ROE.  I am guessing that their cost of capital is higher than 8-9%.  If that is true, than their fair value would be below book value.

 

 

This is something I never have come to understand (likely because I don't have an MBA nor did I ever study the topic). 

 

What do you mean by "cost of capital"?  Are you talking about the cost of their float?  The cost at which they borrow money? 

 

Their float does not cost 8-9%, and they borrow money at less than 8-9%.

 

Even if it did cost them 8-9%, those numbers are pre-tax and their ROE is after-tax.

 

So what exactly is costing them 8-9% in your estimation?

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Eric, Cost of capital=float+debt+equity.  In finance they use capm formula which uses volatility to figure out the cost of equity but that assumes beta is a useful measure for risk.

 

 

Viking, Theres no way you can figure out where there portfolio will trade at tomorrow, 9 months or 5 years from now but until the soft market is over they'll get most of their growth from it so you have to make assumptions or use a range.

During an average relatively calm disaster year they'll generate enough money to buy a company about the size of Zenith, buyback stock or increase portfolio holdings.

 

 

(I apologize for the poor formating earlier)

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Every public company pays a 'fee' for the its assets. If you had a company financed entirely by debt with zero equity, then the cost of capital is explicitly represented by the YTM of the debt.

 

But if you have a debt free company with no growth, no volatility, generating $10 a year, then with a market cap of $100, the market demands a 10% return. You can think of it as the return the market demands when you try to sell more shares to them.

 

So the cost of capital for most companies is the weighted average of D + E.

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Cost of capital? Never used that number, don't need to neither and don't think that I will use it once in my life.

 

“Obviously, consideration of costs is key, including opportunity costs. Of course capital isn’t free. It’s easy to figure out your cost of borrowing, but theorists went bonkers on the cost of equity capital. They say that if you’re generating a 100% return on capital, then you shouldn’t invest in something that generates an 80% return on capital. It’s crazy.”  Charlie Munger

 

http://www.25iq.com/charlie-munger-quotations/

 

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Great quote from Munger. 

 

There are lots of examples of good companies weakening their franchise with the purchase of lower quality businesses. 

  • http://www.rationalwalk.com/?p=6087  Buffett's call-out of Kraft's CEO was classic where a solid pizza franchise was sold at a tax disadvantage to raise capital along with the use of undervalued Kraft stock to pay for the Cadbury purchase.
  • Canwest Global just recently went into bankruptcy where they diluted a television content provider business (20%+ returns) with a newspaper business (sub-10% returns which only got worse) and used a boatload of debt to do it.

-O

Cost of capital? Never used that number, don't need to neither and don't think that I will use it once in my life.

 

“Obviously, consideration of costs is key, including opportunity costs. Of course capital isn’t free. It’s easy to figure out your cost of borrowing, but theorists went bonkers on the cost of equity capital. They say that if you’re generating a 100% return on capital, then you shouldn’t invest in something that generates an 80% return on capital. It’s crazy.”  Charlie Munger

 

http://www.25iq.com/charlie-munger-quotations/

 

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- one catalyst for FFH continues to be possibility of share buybacks. FFH has been quite predictable so far in what they are doing with their excess cash (bought NB, ORH & ZNT). I think the next big move will be share buybacks, assuming earnings stay reasonably strong and shares trade at or below book value. The only question is when do they start?

Viking,

 

If you go back to the 1990 AR (http://www.fairfax.ca/Assets/Downloads/AR1990.pdf), FFH retired 23% of their outstanding shares.  What did it take to make that decision?

"At year-end 1990 our shares were selling at a 36% discount to book value per share as

opposed to a 50% premium when we refinanced the company in September 1985." 

 

There were 2 sources of the shares cancellation -- a sale to Markel and a normal course issuer bid.

"On December 18, 1990 the company received and cancelled 800,000 multiple voting and

850,505 subordinate voting shares as partial consideration for the sale of F-M to

Markel Corporation (note 3). The value attributed to these shares was $14,855 based

on a $9 share price on the date the transaction was completed of which $3,881 was

charged to retained earnings.

In addition, under the terms of a normal course issuer bid approved by The Toronto

Stock Exchange the company purchased and cancelled 188,898 (1989 - 6,000) subordinate

voting shares for an aggregate cost of $2,605 (1989 -$87), of which $1,198 (1989 - $45)

was charged to retained earnings."

 

'A significant event in 1990 was the cancellation of 1,839,403

subordinate voting shares of Fairfax through the sale of F-M

Acquisition  and  through an  issuer  bid  on The  Toronto  Stock

Exchange.  The cancellation represented 25% of the outstanding

shares of the company.  The 1,650,505 shares cancelled in respect

of the F-M transaction were valued at $9 per share based on the

trading value on the date the transaction was completed."

 

 

Since Watsa follows the Templeton school of value investing, I would expect that it will take more than a 10% discount to BV for FFH to make significant purchases on their normal course issuer bid.  If similar insurance companies can be obtained in the marketplace (ORH, ZNT, etc), these expand the capacity of the insurance platform for the hard market.  Another factor mentioned in the 1990 AR is debt reduction:

 

"Since the total debt to equity ratio of 0.87:1, up from 0.2:1 in

1989, is higher than in past years, our main objective for 1991 is

to reduce total debt outstanding so that we can take advantage of

future opportunities. At the Fairfax entity level, cash flows are

dependent on its insurance companies' ability to pay dividends.

Other investments made by the entity will be sold during 1991 with

the proceeds applied to outstanding debt. The company believes it

is in a position to meet all expected cash requirements with its

existing resources."

 

In the 2009 AR just reported, the following is probably the deciding factor against share repurchases:

 

"Our performance in 2009 continued to raise our ratings. A.M. Best affirmed our financial strength ratings at the A

level and S&P raised Fairfax’s debt rating to investment grade and Crum & Forster’s financial strength rating to A–. We

are focused on raising our debt ratings to the A level over time and maintaining them there. This was why we financed

the privatization of OdysseyRe by issuing $1 billion in common equity, and we expect to continue to maintain a

minimum of A level financial strength."

 

I would expect that once the A level is reached and if share prices are well below book value (80% or less) and if there are few high quality insurance companies available and if we're still in a soft market, then the share repurchases will start to go ahead.  It looks like it's still some way off.

 

-O

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omagh, I agree that FFH may use excess cash to make more aquisitions. There is a chance that over the next quarter the economic data from the US could suprise to the upside and risk assets could continue to rally and as a result FFH may decide to monetize some of those massive gains. What to do with the excess? I think it is more likely they will purchase their own shares (below book, lets say at 90%) than make a large external aquisition at 1.3xBV.

 

I do not expect them to buy back 25% of outstanding shares... but I could see a repurchase in the order of 5 to 10% should the stars align.

 

Many insurers / reinsurers are currently buying back lots of shares and most are trading at more than 0.9xBV (not that that says alot)...

 

As per usual, just a guess... 

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Viking,

 

I've been following Watsa for 12+ years and have yet to see a meaningful share repurchase.  I'm guessing that Watsa is predisposed to expanding the platform or maintaining cash on hand.  If one can obtain float at cost ~2%, lever 5x, and generate a spread of 300-700 points less operating costs and insurance losses, it's not a bad approach to expanding the book value of the business.  The A-rating will also have advantages for the platform since it generates a higher spread.

 

If the Templeton approach is 50% discount to 1.3BV, then you're looking at ~0.7BV (~50% discount) to start a meaningful share repurchase. 

 

-O

 

omagh, I agree that FFH may use excess cash to make more aquisitions. There is a chance that over the next quarter the economic data from the US could suprise to the upside and risk assets could continue to rally and as a result FFH may decide to monetize some of those massive gains. What to do with the excess? I think it is more likely they will purchase their own shares (below book, lets say at 90%) than make a large external aquisition at 1.3xBV.

 

I do not expect them to buy back 25% of outstanding shares... but I could see a repurchase in the order of 5 to 10% should the stars align.

 

Many insurers / reinsurers are currently buying back lots of shares and most are trading at more than 0.9xBV (not that that says alot)...

 

As per usual, just a guess... 

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Guest Dazel

 

Viking,

 

Excellent work! Good follow up as well guys. We are disappointed that we are not getting the respect of the market with regards to book value valuation. We are more disapointed that we are not gettting the discount that would attract us to load up! I think Prem would say the same thing. He is likely picking away at shares but we are stuck in an in between range.

 

One thing that sticks out my mind is the fact that Prem went to the extreme of expalining the $2 billion in write offs that Fairfax has taken over the last two years. He concluded that those write offs were far from done other than Canwest. I would expect many nice surprises here over the next year. Someone mentioned the Brick the others will follow. Most of these gains will show in the corporate bond area which we have been very pre mature in predicting would be larger.

 

There is one more ace in the hole. Their team picked out the weak players with exposure to realestate securities and leverage. If they are doing what Paulson and Co. is they have reversed the trade. Those who had the biggest losses will have the biggest gains when the write ups happen. Paulson has made massive bets on the companies that he shorted. Genworth and XL capital for example were two of the cds bets Fairfax made...their stocks have gone from a dollar to almost 20! We would be surprised if we were not surprised by some of these bets Fairfax likely made.

 

Dazel.

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Dazel, I agree. FFH has taken some massive write-downs the past two years on many of its highly speculative positions. As the economy stabilizes and risk markets improve and companies are able to repiar their balance sheets and stabilize their business there exists the opportunity for some very nice gains to be reported.

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$30?  That would be like 8-9% ROE.  I am guessing that their cost of capital is higher than 8-9%.  If that is true, than their fair value would be below book value.

 

 

This is something I never have come to understand (likely because I don't have an MBA nor did I ever study the topic). 

 

What do you mean by "cost of capital"?  Are you talking about the cost of their float?  The cost at which they borrow money? 

 

Their float does not cost 8-9%, and they borrow money at less than 8-9%.

 

Even if it did cost them 8-9%, those numbers are pre-tax and their ROE is after-tax.

 

So what exactly is costing them 8-9% in your estimation?

 

I should have clarified, I meant cost of equity.  Investors in their stock on average are likely buying at the current price anticipating a return greater than 8-9% on an annual basis (probably somewhere between 10-15%).  If ROE is only 8-9%, and investors require somewhere between a 10-15% return, then the cost of equity is higher than ROE and the fair value would be below book value.

 

I was saying I think the 8-9% is low, and I think it is more likely that potential normalized earnings would be between 40-50 (even high if you add a premium for the "prem" factor).  Their goal of 15% ROE would equate to eps of almost $55.

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Keep in mind that the FFH float is actually too small for anything other than `buy & hold forever` purposes (which doesn`t require depth or liquidity); they need to be expanding it, not reducing it.

 

It is a lot more likely that they either do (1) some kind of share split (ie: 5:1) CONCURRENT with a buyback, or (2) a bigger acquisition partially funded with new equity. Logic suggests (1) vs (2), & sometime after the AR (at the earliest).

 

SD

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I dont think that you will ever see meaningful buy backs at Fairfax.  At a certain price (~0.7 book mentioned above) they might but at that price it is very likely external opportunities will be much more compelling yet.  As time progresses they will be more inline with Buffett.  Load up cash until opportunities present themselves.  Get the A-rating in the process and then buy other cheap companies. 

 

There is also the need to finance growth in Brazil, Europe, India, etc. 

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I would observe that we have seen meaningful buybacks from FFH in 2008 and 2009.  In fact, they bought back all of NB and ORH.  This was big bucks, and it was done opportunistically when the share prices were relatively cheap.  It would not surprise me at all to see a large FFH buyback at the holdco level if the price were right and if excess cash were available.  In fact, given the current market valuation for FFH and current valuations for the stock market more broadly, I suspect that share buybacks would figure prominently in FFH's strategy if they had an extra billion or two of capital laying around.... 

 

In any event, IMO nothing major will happen for 2010 or 2011 as they need to finish digesting the $1b ORH buyback and the $1.3b Zenith acquisition....both of those blew some serious capital out the door.

 

SJ

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In any event, IMO nothing major will happen for 2010 or 2011 as they need to finish digesting the $1b ORH buyback and the $1.3b Zenith acquisition....both of those blew some serious capital out the door.

 

SJ

 

I think they are actually much more capable of further acquisitions now.

 

First off, you state they need to digest the ORH buyback even though it was paid for by selling $1b in FFH shares.  Secondly, the Zenith purchase of $1.3 billion... most of that was funded from last year's profit in addition to YTD profit.

 

So compared to where they started last year they are stronger for two reasons:

1)  acquisitions were paid for out of capital raises & earnings

2)  they now have significantly higher cash flows at holdco.  MUCH higher... added dividend capacity of ORH and Zenith is huge

 

Bulging with cash despite acquisitions (from 2009 AR):

"This increase in shareholders’ equity, together with the decrease in net premiums written due to the soft

markets, has resulted in a build up of very significant excess capital in our insurance and reinsurance subsidiaries."

 

The soft market has freed up capital to deploy elsewhere.

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