E-L Financial ELF.TO
September 28, 2004 - 12:13am EST by
2004 2005
Price: 355.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 1,400 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Despite the fact that the E-L Financial’ stock price has risen over the past 2 years and the hard market for insurance has begun to soften, E-L Financial still represents a compelling and undervalued long-term wealth creation investment. At a price of $355, it trades at roughly 97% of June 30, 2004 book value.

Recent Value Creation Initiatives
In addition to solid operating results over the past few years, E-L Financial also paid a $24 dividend ($7.20 in cash and $16.80 in stock) in the second quarter of 2004 in order to recover a refundable dividend tax credit, thus showing its commitment to enhancing shareholder value.

Company Description
E-L Financial (ELF) is a Canadian investment holding company (all numbers in this write-up are in Canadian dollars) that trades on the Toronto Stock Exchange at a substantial discount to the sum of its parts. ELF’s strategy is to accumulate wealth within each area of investment. ELF has investments in 3 areas:
1) an investment portfolio of publicly traded fixed income and equity securities, owned both directly and indirectly through a number of closed-end investment fund corporations and other investment companies
2) a 100% interest in the Dominion of Canada General Insurance Company, a property and casualty underwriter,
3) an 80% interest in the Empire Life Insurance Company, a life and health underwriter.

Investment portfolio
First, this investment portfolio is outside of and in addition to the investment portfolios of ELF’s two insurance companies. The following table summarizes the market values of the investment portfolio (pre-tax) at December 31
2003 2002 2001 2000
Short-term investments $42.8mm $46.6mm $57.3mm $31.1mm
Bonds and debentures 96.7mm 132.2mm 118.5mm 118.7mm
Common and preferred stock 540.4mm 411.0mm 439.4mm 406.7mm
$679.8mm $589.8mm $615.1mm $556.4mm

The investment portfolio is carried at market value on the balance sheet and the difference between cost and market value is recorded as unrealized appreciation of investments (net of taxes) in shareholders’ equity. As at June 30, 2004, the market value of the investment portfolio net of taxes was $680mm or $169 per share.

Dominion of Canada General Insurance Company
In existence since 1887, Dominion is a mid-sized Canadian property and casualty insurer offering both personal and commercial products, distributed solely through its network of approximately 560 independent brokers. Dominion participates in all major lines of business in the property and casualty marketplace. Business line and geographic mix have been relatively consistent over the past few years. Automobile insurance comprises 64% of the business; personal property is 19% and commercial property and casualty lines account for 17%. Approximately 70% of Dominion’s business in based in Ontario, 14% in Alberta, 11% in the Atlantic provinces and 6% in the Pacific region (mostly property insurance). The following table (in Canadian $ millions) summarizes Dominion’s operations:

Auto Pers. Property Comm Prop&Cas Total
2003 2002 2003 2002 2003 2002 2003 2002 Gross written premium $676 $507 $198 $164 $189 $141 $1,063 $812
Growth 33.2% 22.2% 21.3% 14.7% 34.0% 34.4% 31.0% 22.7%
Mix of business 63% 62% 19% 20% 18% 17% 100% 100%
Net earned premium $597 $452 $166 $139 $152 $111 $915 $702
Net income $20.3* $22.0
Return on avg equity 5.0% 5.7%

* Includes a net realized investment loss of $15.8 mm (net gain of $10.6 mm in 2002).

Dominion’s combined ratio declined to 101.9% in 2003 from 104.2% in 2002. Management is still working to lower the combined ratio, though given the competitive nature of the P&C industry, substantial further improvement is unlikely.

The following table (in Canadian $ millions) summarizes Dominion’s investment portfolio as at December 31:
2003 2002
Cash and short-term investments 18% 13%
Bonds 47% 47%
Common and preferred stocks 33% 38%
Other 2% 2%
Total 100% 100%

As at December 31, 2003, 27% of the bond portfolio is scheduled to mature within 2 years.

Data for the six months ended June 30 is as follows:
2004 2003
Revenue $572 mm $431mm
Net income $35 mm ($4 mm)

Dominion’s book value at June 30, 2004 was $481 million. Assuming a 1.3x to 1.5x book value multiple, Dominion is worth approx $625 million to $722 million or $156 to $180 per ELF share.

In order to derive the book value multiples used above, I looked at the Canadian P&C industry. Two imperfect comparables are Kingsway Financial (see VIC write-up) and Northbridge Financial. Kingsway is in non-standard auto, has large US operations, is in the process of turning itself around and trades at 1.2x book. Northbridge Financial (Fairfax’s Canadian subsidiary), which is larger than Dominion and has a slightly different business mix (less weighted towards auto) trades at about 1.5x book. Since Dominion isn’t in the turnaround process, I used a low-end multiple of 1.3x and a high-end multiple of 1.5x.

Empire Life Insurance Company

In existence since 1923, Empire Life is a stock company and has both shareholders and participating policyholders. Each group participates in the earnings of the Company. Shareholders are entitled to all the earnings of the non-participating section of the business and ten percent of the distributed income of the participating section of the business. ELF has an 80% interest in Empire Life.

Empire provides a full range of life insurance, investment plans and annuities, employee benefit plans and financial services to meet the needs of individuals, professionals and businesses through a network of regional financial resource centers and group sales offices across Canada and through an independent national network of Managing General Agents and their brokers. In terms of assets, Empire ranks among the top 15 of Canadian life insurance companies.

In 2002, 58% of premium income came from Ontario, 24% from Quebec, 16% from Western Canada and the remainder from the rest of Canada (2003 should have a roughly similar geographic distribution, but no disclosure was provided). The company has strong capital ratios and an A rating from AM Best.

The following table sets out the 2003 revenue derived from major lines of business (in Canadian $ millions):
Premium Fee,Invest&
Income Other Income Total
Wealth Management $106.0 $103.9 $209.9
Employee Benefits 168.2 6.9 175.1
Individual Insurance 169.1 78.5 247.6
Capital & Surplus - 36.3 36.3
$443.3 $225.6 $668.9

The following tables summarizes the 2003 net income contribution from each of the business lines (in Canadian $ millions):
2003 2002
Wealth Management $2.5mm $5.8mm
Employee Benefits 11.0 5.4
Individual Insurance (25.3) (18.0)
Capital & Surplus 26.7 19.7
$14.9mm $12.9mm
Net profit contribution
To ELF after policy-
Holder adjustment,etc. $14.1mm $11.6mm

The majority of the investment portfolio is in bonds (57%) with the majority of bonds being governments and high-grade corporates. Preferred stocks represent 7% of the portfolio with common stocks representing 20% of the portfolio.

Data for the six months ended June 30 is as follows:
2004 2003
Revenue $341mm $331mm
Net income $12mm $17mm

Empire’s book value at June 30, 2004 was approx $311 million. Assuming a 1.3x to 1.6x book value multiple, Empire is worth approx $404 million to $498 million or $101 to $124 per ELF share.

In order to derive the book value multiples used above, I looked at the Canadian life insurance universe which trades at an average of about 1.9x book. Industrial Alliance (IAG), the smallest public company comparable which operates mainly in Quebec, trades at about 1.8x book. Since Empire is about 1/3 the size, I used a multiple range of 1.3x to 1.6x.

The Jackman family (Hal Jackman was former lieutenant governor of Ontario) owns 35.1% of ELF. Third Avenue is also a shareholder. Well-known Canadian value investors ABC Funds (Irwin Michael) and Gluskin Sheff are shareholders as well.

The company is opportunistic both in terms of acquisitions and divestitures. During the Canadian bank merger mania, they sold their National Trust operations at a very good price. ELF has a strong balance sheet with no debt allowing it to make opportunistic value-enhancing acquisitions.

One of the main reasons for the low share price is the fact that not single investment analyst covers ELF. Furthermore, ELF has made little effort to make itself accessible to the average investor (high share price a la Berkshire Hathaway).

There are no options issued so there is no need to worry about options dilution.

In 2002, Hal Jackman retired as Chairman of the ELF, but stills sits on the board. From 1968 to year-end 2002, a 35-year period mainly under Hal Jackman’s leadership, book value compounded at 14% per annum. His son, Duncan Jackman, is now Chairman and President of ELF. He understands how insurance companies create wealth and how they can be destroyed through poor underwriting and/or poor investing.

From year-end 1998 to year-end 2003 (a 5-year period), compound growth in book value was 8% per annum (a very tough period for the P&C industry).

Downside Risk: ELF is run very conservatively and though the market price could decline, there is a sufficient margin of safety at the current market price to offset some business deterioration.

Value per share
Investment portfolio $169
Dominion $156 to $180
Empire Life $101 to $124
Total $426 to $473 (midpoint = $450)

At a price of $355, ELF has almost 30% upside potential to the conservative and growing $450 sum of the parts valuation. Assuming intrinsic value can grow at 8% per annum (in line with book value growth) and the discount between the trading price and intrinsic value disappears, this represents 85% upside over the next 5 years.

Please note that if just book value was used for Empire and Dominion, this would equate to a value of about $197 per share, plus the value of the investments of $169 per share for a total of roughly $366 per share versus a trading price of $355 (97% of book value).


Cheap valuation, dividend increase (current dividend is $0.50 per share annually), share buyback, share split, potential acquisition, potential sale of either Empire or Dominion as the insurance sector consolidates.
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