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Fairfax Launches $150 Million Senior Notes Offering

 

Press Release

Source: Fairfax Financial Holdings Limited

On Wednesday August 12, 2009, 9:56 am EDT

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Companies: Fairfax Financial Holdings Ltd.

TORONTO, ONTARIO--(Marketwire - 08/12/09) - (Note: All dollar amounts in this press release are expressed in Canadian dollars.)

 

 

 

Fairfax Financial Holdings Limited (TSX:FFH - News)(NYSE:FFH - News) announces that it intends to offer $150 million in aggregate principal amount of 7.5% Senior Notes due 2019.

 

The Senior Notes will be offered through a syndicate of dealers to be led by BMO Capital Markets that include RBC Capital Markets, CIBC World Markets, Scotia Capital, Bank of America Merrill Lynch, GMP Securities and Cormark Securities. The notes offered will be unsecured obligations of Fairfax and will pay a fixed rate of interest of 7.5 per cent per annum. Fairfax intends to use the net proceeds of the proposed offering to augment its cash position, increase short term investments and marketable securities held at the holding company level and for general corporate purposes.

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I think this is most likely just an opportunistic debt offering; spreads have come in a great deal and inflation in likely to pick up at some point in the next ten years.

 

It certainly looks like they might buy back the rest of ORH, and this is one more piece of evidence, but there are plenty of stand-alone reasons to offer this debt right now.

 

For those keeping score at home (like me), mounting pieces of evidence of an ORH buyout:

1) NB buyout

2) continuing ORH buybacks

3) cash preservation at FFH and lack of buybacks despite similar discount to ORH during same time period as ORH buybacks

4) today's debt offering

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There's no need to push out the 2012 debt unless there is some other capital requirement anticipated.  The purchase of ORH is one possibility, an acquisition of some other company is a second possibility, or the anticipation of  a hard market is the third possibility.  I would say repurchasing ORH is the most likely use for this cash. 

 

At today's prices, it would take about $800 m to repurchase the outstanding float for ORH.  Looking at the premium:surplus ratio, it would appear that ORH could issue a dividend of $500m without even remotely triggering any capital adequacy issues.  So, if you take $150 in new debt, add a potential post-takeover dividend of $500m, and then tack on another $350m in FFH holdco cash, that would get you $1b which would be roughly enough to buy the ORH float (ie, a 25% premium over today's market).

 

FFH held $880 in cash at the end of Q2, so my scenario above would take holdco cash down to about $500m, which was the magic number to which Prem made reference several years ago as his preferred minimum holdco cash balance.

 

Eat you own cooking!

 

SJ

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Personally, I would much prefer Prem keep at least as much cash as there is holdco debt...so currently they should keep about $850M+.  That $500M number is too low for my tastes, and I think as long as they've got as much cash as debt, the rating agencies will be happy. 

 

As far as Odyssey is concerned, I don't think they should take it private.  It's a reinsurance company and that means there will be periods of substantial catastrophe losses...think about an 8.0 earthquake in the middle of Los Angeles.  You want Odyssey to be able to access the capital markets, either through debt or equity, if the need ever arises.  Cheers! 

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Dont forget by next quarter the holdco. will have another round of dividend and interest income paid to them via the investment portfolio.  If I remember off the top of my head that was somewhere in the mid-150-170Million mark?  Add that to the mix and your third quarter cash is 750 Mill +/- Underwriting gains with the assumption no bonds/stock were sold.  I would be comfortable with that.

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Sanjeev ... good point about cash at holdco level, the $500M # is probably outdated given they have higher equity base now than a few years ago ... but wouldn't ORH be still able to access debt markets if taken private ... and presumably the pref market as well?  FFH could always access capital/debt markets as parent, and inject/distribute accordingly?

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As far as Odyssey is concerned, I don't think they should take it private.  It's a reinsurance company and that means there will be periods of substantial catastrophe losses...think about an 8.0 earthquake in the middle of Los Angeles.  You want Odyssey to be able to access the capital markets, either through debt or equity, if the need ever arises.  Cheers!

 

If they buyout the company down the road, ORH can still tap the debt and equity markets. ORH would still issue ORH debt, nonrecourse to the parent FFH, even with 100% ownership. If the ORH division got into trouble they could still tap the equity markets with a partial IPO on ORH, as was the case in early 2000s.

 

It would grant the parent, FFH, much more flexibility in moving cash around from the subsidiaries, baring restrictive covenants on the subsidiary debt, if the parent needing extra holding company cash, for any reasons.

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FFWatcher, I hold ORH because I think they are a good value and offer terrific upside:

1.) there is a good chance book value will grow better than 20% this year and 15% in coming years

2.) hard market in insurance will likely come in next 24 months

3.) should FFH continue to grow cash at hold co buying 30% of ORH they do not own becomes more likely (if ORH continues to trade around 0.9BV).

 

I would not own ORH to wait for FFH takeout.

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Prem was comfortable in the past with $500 million at holdco to entertain opportunities and potentially help subs if they were in trouble. That is a number he mentioned at a past annual meeting relative to what he thought would cost a major earthquake in California. I don't see why we need $880 million today which is likely more $1 billion now. All the subs are over-capitalized, debt repayments are far out and well spreaded.

 

By the way, if ORH is hurt badly, it won't be any easier or cheaper to raise cash in the public market being public. We have seen at Fairfax what it is like to raise capital when the Street is scared. So if the company is any good and worth owning for Fairfax what is the difference between owning 80 and 100%? If ORH is that scary, we should only own 20 or 25%.

 

IMO, this offering is as close to tell investors that they will buyout ORH without telling them. Every other action points in that direction. On top of that, ORH is very attractive with a book value of $51.90, now more like $55? And operating income of at least $5. You can buy it without even considering a take-over possibility.

 

Some were not happy when I mentioned that FFH combined ratios were not terrific. The key issue there is the loss ratio which has nothing to do with staffing or overhead. It is pretty much always above 60% and closer to 70% at times. Chubb at their commercial division had a loss ratio of 57% last quarter while Crum & Forster did 66%. Very similar policies, length of tail, etc.

 

Why is that? A possible answer could be due to size, ratings and reputation. If the client has a choice between a Chubb policy and a Crum & Forster policy with same coverage at same price, it is likely that the client will pick Chubb. So to get that business, Crum & Forster has to lower its price. They would still be disciplined but, they are suffering from a competitive disadvantage. With same loss or claims, it means that C&F policies are priced 14% cheaper than Chubb. However, it seems like a lot to me for that reason alone, so they could still be agressive a bit to get that premium to invest since they are so good at it.

 

So what it has to do with ORH? IMO, it would make a lot of sense for Fairfax to integrate its subs differently and develop a strong name. Not 15 odd names, but one. Something recognizable for clients with a strong rating. A brand if you will. It could go a long way to reduce that loss ratio which I believe has something to do with what I mentioned above. These guys are thinking long term and it has to be more than just long term with their investments. They must be thinking about continuous improvements for the insurance business too. Just eliminating public listing costs and integrating overhead are nice cost savings alone following a take-over. Eliminate non-controlling interest, that would be nice.

 

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It's fun to speculate, yet i don't think the debt offering by FFH was to purchase ORH. I think it is likely that ORH just continues undervalued buybacks of their own shares, proportional to their recurring investment gains, as long as ORH remains overcapitalized and undervalued. Perhaps when the non-Fairfax ownership gets closer to the 85-90% range, they may purse using Fairfax funds to purchase ORH shares (But that is just speculation). Being a shareholder of both companies, i would prefer ORH to continue undervalued buybacks for a while longer before any outright purchase by FFH, which would likely be done at a premium to book.

 

Interesting to think that roughly 10% of the total non-Fairfax owned shares were repurchased in the four month period ending July 30th. At that rate, they can decrease the ORH float significantly, (and progressively on a percentage basis) over the coming quarters provided the shares remain such a bargain.

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Why is that? A possible answer could be due to size, ratings and reputation. If the client has a choice between a Chubb policy and a Crum & Forster policy with same coverage at same price, it is likely that the client will pick Chubb. So to get that business, Crum & Forster has to lower its price. They would still be disciplined but, they are suffering from a competitive disadvantage. With same loss or claims, it means that C&F policies are priced 14% cheaper than Chubb. However, it seems like a lot to me for that reason alone, so they could still be agressive a bit to get that premium to invest since they are so good at it.

 

Cardboard

 

I'm not sure if I'm right about this, but I suspect if HWIC were managing Chubb's portfolio identically to FFH's then the ratings agencies would cut Chubb's rating due to investment risk (heavily in equities).

 

Can you have both the credit rating and the freedom to go heavily into equities?  Or do the ratings people not care (can't imagine this to be the case).

 

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Prem was comfortable in the past with $500 million at holdco to entertain opportunities and potentially help subs if they were in trouble. That is a number he mentioned at a past annual meeting relative to what he thought would cost a major earthquake in California. I don't see why we need $880 million today which is likely more $1 billion now. All the subs are over-capitalized, debt repayments are far out and well spreaded.

 

I'm of the opinion that an umbrella won't do you much good during a flood.  They've got enough leverage through float and asset to equity leverage, keeping a few hundred million more in the kitty would have a negligible effect on returns, but the credit rating agencies would view it as a positive.  Cheers!

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FFH borrows $150M @ 7.5% and ORH buys back $150M in their own shares.  Globally they have as much cash available and FFH benefits from 80% of the buyback through their current ownership position.  Since ORH is expected to return 15%, FFH will get a better return than the interest cost.

 

This also acts a hedge.  If ORH shares drop (major disaster, market collapse or continuing soft market) then they will get ORH at an even better price.  In my opinion, FFH is just loading the gun.

 

All though $150M is a relatively small amount, it will still buy back 3 million shares at the prices that ORH has paid so far in 2009.

 

 

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First, if Fairfax is truly interested in better ratings, then I think that the last thing one would like to do is to issue more debt or to increase leverage. Assuming it is all held at holdco, we now have over $1.1 billion in cash and investments. Ratings agencies will always assume a low return on that, at least lower than the 7.5% that they are paying even if that is not reality. I believe that there is a grand plan at work here, but we will see.

 

Second, let's explore that a bit:

"I'm not sure if I'm right about this, but I suspect if HWIC were managing Chubb's portfolio identically to FFH's then the ratings agencies would cut Chubb's rating due to investment risk (heavily in equities).

 

Can you have both the credit rating and the freedom to go heavily into equities?  Or do the ratings people not care (can't imagine this to be the case)."

 

It is absolutely correct that Chubb has a tiny amount invested in equities. It may help their ratings and give them a boost to their loss ratio. For them an underwriting profit is a must. I am not convinced that it is the only reason for the big difference in the loss ratio, but you got a valid point.

 

Also, if you are correct, then I believe it is logical to assume that Fairfax will never show an underwriting profit over the long term. The combined ratio will be too high during good years to absorb the losses of bad years. Then most of the income on bonds will likely be also absorbed by these catastrophes and our interest cost. So what we are left with are the equities in the investment portfolio.

 

So after all this insurance mumbo jumbo, taking all these risks and being levered with debt we end up with less than 30% in equities in the portfolio as of June 30 (and that is after massive appreciation!) or something like $1.07 for every dollar in common equity: only 7% more than they would have in a regular cash brokerage account.

 

I just find the model bizarre: high risk, low reward. A ton of assets, a ton of liabilities and only a tiny portion within assets that can move the needle? I think that there is room for improvement like in any business and that part is not right IMO. Either combined ratios have to get better to generate more income or they need to find a way to increase their equity weighting in their portfolio. 15% growth in book value should be an easy target with the talent at HWIC. It is just the structure that needs some improvement to unleash that power.

 

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