Description

INVESTMENT THESIS

At its current price, I believe the expected value of an investment in Fairfax Financial Holdings (“FFH”) is extremely compelling. FFH, a Canadian insurance company, was first written up by Nish697 last September and I recommend reading that write-up in conjunction with this one. With few exceptions, property and casualty insurance is not an industry that lends itself to a high degree of certainty with respect to downside valuation estimates. Its commoditized nature and inherently leveraged business model make it difficult to price in a sufficient margin of safety to largely eliminate the risk of permanent loss of capital. The presence of such risk does not negate an attractive expected value however, and in FFH's case, I believe the market has priced the business to a level reflective of the belief that the factors that have been driving its poor recent financial results are permanent, when in all likelihood there continued recurrence is a low probability event.

FFH trades at 0.7x book value and less than 7x estimated run-rate earning power. I conservatively estimate the company's intrinsic value at $225-250/share. Recent results have been poor, largely as a result of the fallout of FFH's aggressive acquisition spree in the late 90s and the hurricanes of 2004/2005, but there remains only one major risk that is difficult to quantify; that being the company's inclusion in the ongoing SEC investigation into improper accounting for finite reinsurance.

Presented with ten opportunities like FFH, I would expect seven of them to work out well. For me, the absence of a high degree of certainty on the downside renders this a special situation and I have chosen the LEAPs to take advantage of the attractive expected value. Additionally, in purchasing the LEAPs the high degree of leverage mentioned above largely becomes a redundant risk as the option-holder is already accepting the risk of near-term operating underperformance.


BACKGROUND

For the better part of 15 years, FFH management led by Prem Watsa, was able to compound book value at an extraordinary rate (35% per year from 1985-2000). The stock price followed and at its peak traded at 3x book in 1998. These spectacular results were largely a result of an aggressive acquisition strategy in combination with effective asset management.

Growth via acquisitions is a double-edged sword in most businesses but particularly in the insurance industry; it allowed FFH to grow the asset base rapidly but in a manner that made it extremely difficult to quantify the liabilities assumed for years. The company tripled in size from 1996 to 1998 through acquisitions, but this meant that nearly 2/3 of the net premiums written during the severe soft market of 1997-2000 were not under FFH's control (these businesses were in transition mode at best).

The result was that the company's terrific run completely stalled, and at the end of 2001 nearly half the company's reserves were from business lines that had been put into runoff. From 2002-2005, operations put into runoff cost the company $1.1B pre-tax, more than half of that occurring in 2005. Adding to the distress were the record losses imposed on the industry by the 2004/2005 hurricanes, which cost the company another $1B pre-tax ($710 MM in 2005). These circumstances put a lot of strain on the company's financial resources and ultimately forced FFH to sell equity in its subsidiaries and at the holding company level.


ANALYSIS

There are two basic variables that drive the value here:
1. Expected return on the portfolio assets
2. Expected size and cost of the asset base

With $400/share in portfolio assets still at work for the shareholders excluding those tied up in runoff operations, debt, minority interests, and funds withheld for reinsurers, even a 7.5% long-term return on assets (mangement's long-term track record is over 9%) and a slight underwriting loss (2% cost of float) implies run-rate earning power of $15/share. Achieving an 8% ROA and break-even underwriting results increases earning power to $20/share. The invested capital/share is comprised of $100 of tangible book equity per share and $300 per share of float (the company has taxes recoverable of $1B which adds to the value and brings actual book value per share to $160).

o At its current price, FFH is trading at less than 6.5x the mid-point of this range of run-rate earning power.

o The achievement of an ROE in the low to mid teens going forward would imply a fundamental value of at least $200-250/share. There is an additional $20+/share of value depending on the timing of the tax recovery.

o While book value multiples have their limitations, it is worth noting that typical P&C insurers are trading at 1.4x book value. Further, Markel Corporation by comparison trades at 14x its run-rate earning power (MKL's current earnings are also depressed as a result of hurricane losses).

The track record of management over the last 20 years on the investment side provides a sufficient level of comfort that a 7.5-8.5% pre-tax return on portfolio assets is highly likely, therefore the major area of risk is with respect to the size and cost of the asset base. The following are the primary determinants of what the size and cost will be going forward:

o Pricing environment - margins will remain steady only if rates rise as fast as costs, and a softening insurance market is not only a possibility - it is occurring in this cyclical business outside of gulf wind policies. But the margin of safety here seems significant. Consider a permanent 33% decline in net premiums which would cause a $120 decrease in the amount of float/share over time (the decline of 40% is disproportionate because the assets excluded for debt, runoff, and funds withheld would not be affected). A permanent decline of this magnitude would certainly be an extreme case given that management has grown assets in all but 2 of its 20 years in business. At these levels, the earning power would still likely be around $14/share which supports a valuation close to $200/share. It is important to note that additional cushion should be provided by the runoff group, where management eventually expects meaningful assets to free up.

o Realization of reinsurance recoverables - the company's relatively large recoverables position has been a major source of criticism by the company's short sellers, and would certainly indicate an overstatement of the asset base if these are significantly under-reserved. But consider the following:

o Over the last four years the company has averaged 0.4% dilution of gross recoverables as a result of bad debts (the maximum in any single year over that period was 0.7% in 2004).

o It would take approximately a 10% ($0.7B) write-down of gross receivables before a year's worth of earning power would be wiped out, and this still wouldn't be a major problem in isolation (wiping out a year's earnings would not hit book value or affect intrinsic value materially). This seems large and also ignores the fact that the company has $2.5B of security against these recoverables. If even half of the “defaulting” counterparties' obligations were backed by deposits, the size of the write-down required to wipe out a year's worth of earning power would increase to 20%.

o From a credit perspective further consider that the recoverables are relatively fragmented - spread across 50+ counterparties with only 4 accounting for 5% or more of the total on a net basis; 83% currently are rated A or better; and the Company has purchased significant credit insurance (credit default swaps). The prospect of a widespread inability to pay appears remote.

o That leaves the prospect of a large write-down due to the unwillingness of the counterparties to pay. The counterparty fragmentation as well as the reputation considerations at play would also seem to make the prospect of significant widespread defaults on this basis remote.

o Adequacy of current loss reserves and underwriting risks going forward - always a critical consideration with an insurance company. Four specific areas to assess:

o Asbestos, pollution and other hazard (APH) claims - the company has $2.1B of gross reserves for APH claims ($1B net reserves of which $680MM are asbestos-related). The nature of these claims makes reserving extremely difficult and the possibility of future reserve adjustments is not insignificant. However in isolation it would take a huge upward adjustment of these reserves (40% on a gross basis and likely much higher after adjusting for reinsurance) to wipe out one full year's earnings. Further, it is worth noting that current asbestos reserves would be sufficient to cover 9.5 years worth of claims payments based on the average payment experience for the last 3 years. Any potential adjustments are most likely to occur well into the future rendering the present value impact far less significant.

o Catastrophe exposure - recent events provide some comfort that the company manages these risks in a manner that does not pose a major threat to value. The record 2005 hurricanes cost FFH $700MM - a horrible outcome to be sure but one which would not have even caused a pre-tax loss if not coupled with the $550MM of losses arising from runoff operations. The 2004 hurricanes, which cost the P&C industry more than any other year until surpassed by 2005, only cost FFH $250MM - less than half of one year's run-rate pre-tax earning power. Finally, management has indicated that they have scaled back their gulf wind exposure somewhat and pricing for these policies is significantly up in 2006.

o Runoff operations - this has been the biggest source of pain for the company as reserve strengthening and restructuring efforts (commutations and operating cost reductions) have cost the company $800 MM pre-tax over the last 2 years. But the magnitude of the risk here is declining - runoff reserves are now 26% of total net reserves versus 46% in 2001 - and primarily relates to any incremental working capital that may be required (see Holding Co. Liquidity). Further, the recent restructuring efforts within the runoff group are likely to allow investment income to cover operating costs for the first time.

o Improper accounting of finite reinsurance - the exposure here is very difficult to quantify. I have used the AIG case with the SEC and DOJ as a proxy to try to make an assessment. Following notification that it was being investigated, AIG completed an internal investigation in conjunction with its auditors, PricewaterhouseCoopers (PWC). The results were as follows: 66 insurance transactions were restated resulting in a write-down in 2004 book equity of $2.3 B (2.7%), it revealed that the purpose behind a number of the transactions was to boost reserves to appease analysts, it further revealed that the auditors and regulators had been lied to, and CEO Hank Greenberg left the company. Ultimately AIG settled with the authorities for $1.6 B (which includes $800MM set aside for claims that arise out of shareholder litigation).

FFH also conducted an internal investigation in conjunction with its auditors, PWC, after being subpoenaed. The company announced that its investigation revealed no material changes. While far from a perfect analytical tool, this simple assessment provides some indication that the likelihood of a fine in excess of one year's earning power is remote.

o Holding Co. liquidity/ratings- the company's relatively high degree of leverage makes it dependent on consistent dividends from the operating subs to cover their fixed charges. The working capital requirements of the runoff group have more than doubled holding company's annual cash requirements. A rough estimate of FY2006 operating cash flow sources and uses looks as follows:

Operating Sources Uses
Dividends $125 Runoff $275
Mgmt. Fees 55 Interest Exp./OH 90
Interest Income 25 Principal Rep. 60
Asset Sales (Zenith) 200 Dividends 30
Total $405 $455

Guided by the rating agencies, FFH would like to maintain around $0.5B of cash at the holding company. Barring a material negative surprise, the company should be able to meet its cash obligations and maintain its targeted cash balance this year (FFH had $560 MM of cash on hand to begin the year). It remains to be seen what the ultimate working capital investment required in its runoff group will be, but given that the Swiss Re cover is expected to start paying in 2009 (and could possibly be commuted earlier) the maximum potential shortfall is likely to be less than 10% of my estimate of intrinsic value.

The aforementioned all represent real risks, but when quantified are not sufficient to negate the attractive expected value this opportunity currently represents. This is not to suggest that these considerations are incapable of eliminating the estimated price/value gap and causing a loss (particularly the SEC issue) - it simply means that the probabilities are low.



CONCLUSION

The bet is that the bulk of the painful integration work (imposing underwriting discipline, shutting down unprofitable lines, and reserve strengthening) has been completed over the last four years, and that the inherent risk of the business has been reduced substantially. As the drag on earnings caused by the acquisitions of the late 90s comes to an end, the price should come to reflect the value implied by the normalized earning power of the business. A resolution to the SEC investigation should also occur prior to expiration of the 08 LEAPs. Finally, the short interest on this company remains high - nearly 3MM shares on 18MM shares outstanding and average daily volume of less than 100,000. This could further accelerate the closure of any price/value gap if the company performs.

Catalyst

Three conditions that would likely lead to a significant closure of the price/value gap:
- a hurricane (catastrophe) season less remarkable than that experienced in 2005
- evidence that the major losses associated with runoff operations are in the past
- an acceptable resolution to the SEC investigation