Fairfax to acquire Tower – bargain hunting for cheap float

Prem Watsa of Fairfax Financial Holdings (aka Canada’s ‘Warren Buffett’) has announced it will make its first acquisition down-under with a NZ$197m offer for New Zealand based Tower Limited.

Let’s take a look at the deal in more detail to see why this stacks up as a good acquisition for Fairfax.

1) Earthquake provisions driven Towers stock down…

The market has clearly mispriced Tower’s stock in recent times as seen by the 65% reduction in its share price over the last two years. But why?

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There have been two changes that have driven the stock price over the last few years.

  • The first being the divestments of Tower’s Life, Health and Investment businesses resulting in what has been a pure P&C insurance play over the last couple of years – a good outcome driving the rally to ~$2.25/share
  • Reported net losses in the last two years (FY15 $6.6m, FY16 $21.5m) resulting in the stock falling towards ~$80c/share prior to the deal being announced.

The P&L below highlights these recent losses, which are largely driven by below the line items. Despite these being “one-offs” the market has largely ignored the underlying profit which was most recently $20.1m in FY16. At face value, the $197m acquisition price implies a trailing underlying PE of 9.8x – not a bad starting point for a favourable deal.

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However, the markets reaction to these results suggests it does not believe these one-offs are indeed one-offs as can be seen by the $36.2m impact in FY15 and $25.3m impact in FY16 – these were are result of increased claims provisions related to the Feb-11 Canterbury earthquake. The run-off of these liabilities has been complex, but Tower’s net provisions currently stand at only $41m with 89% of claims by number having been settled and 96% by value. To make matters worse, there are disputes related to reinsurance recoveries from the Earthquake Commission (EQC) of $58m and one its reinsurers for $44m which provided adverse development cover.

2) The volatility of past business masks the profitability of new business…

The markets frustration with Earthquake related costs being volatile on the P&L is understandable. However, the share price reaction has been too harsh providing the window of opportunity for Fairfax to acquire it cheaply. Managements answer to unlocking value was to split the business into two “New Tower” and “RunOffCo” – effectively separating the good business from the bad business. This would have likely worked, but Fairfax has jumped in before implementation.30358865-14866481373366995_origin

3) Tower has quality float, made cheap by the markets frustration with EQ losses

With Fairfax being a “mini-Berkshire” we can look at this insurance acquisition under the lens which Buffett also looks at them – cheap quality float. What we see is that despite paying $1.17/share or a 47% premium to market, the acquisition is in fact very cheap.

  • Underwriting profitably – Tower has average NEP of ~$250m with average underwriting margins of 9% meaning there is no cost to the float – indeed it is throwing off very healthy profits. With claims ratios of ~50% and management targeting expense ratio of <35% in the future, is it feasable that the business could deliver an 85% COR (or 15% underwriting margin).
  • Acquiring Float – Tower’s FY16 accounts showed $1.66/share of cash and investments. Compared to the $1.17/share price offered, this suggests Prem Watsa is acquiring float for 70c in the $.

Another way to look at it is if Prem achieves a 5% after tax return on the investment book and underwriting can achieve an 85% COR, that would equate to around 23c of EPS, putting the deal on a 5x PE. Not bad…

However, the issue is obviously around the earthquake provisions which Fairfax is also acquiring. What if these blow up?  Given these liabilities are 90-95%+ developed, a major blowout is probably unlikely. While the $41m of claims reserves should account for any future payments, further volatility (both positive and negative) is possible as the business runs -off and capital is released.

If we hypothetically assume that the FY16 reserve deterioration of $25m is ongoing and continues to repeat (a bear case), then these losses can largely be offset through $25-30m of underlying profitability of current business. It would appear in a bear case, the good business can fund losses in the bad business and in the meantime Prem still gets to keep the float that he acquired at 70c per dollar. Not a bad downside scenario – and significant likely upside should the run-off business behave!

In an ideal scenario Prem has paid $197m in exchange for $280m of Investments and $25-30m of annual profit! This is a great deal by any measure. It does make me wonder why Tower’s board has unanimously supported the deal and isn’t shopping around for a better offer, and why major shareholders representing 18% of the shares have voted in favour of the deal.

The Future Of Berkshire’s Float – From Insurance To Uncle Sam

I’ve been spending a lot of time studying Berkshire Hathaway’s float with the aim of deconstructing its capital structure. As I read and re-read Warren Buffett’s annual letters his true genius continues to fascinate me.

While many readers will know Berkshire is re-known for its insurance float, it will soon be surpassed by its deferred tax float. While one form of this float is unrealised capital gains, the more material source is being generated by depreciation related deferred tax liabilities from the capital intensive businesses such as BNSF (rail-road) and MidAmerican (Utilities). As such, these infrastructure acquisitions were just as much about generating new sources of float as they were about buying ‘great businesses’ – the two ideas go hand in glove.

Float growth is a key driver of intrinsic value for Berkshire, however, now that insurance float is maturing, Buffett needs new and innovative ways to grow it. Railroad assets like BNSF have useful lives of 100 years and will generate deferred tax liabilities for decades after Buffett’s succession – the tax man ‘Uncle Sam’ is a key player of Berkshire’s future…

Read the full article here^

^If you cannot access the link please click here

This research is a complimentary addition to the work on Floats and Moats by The Fundoo Professor

Buffett’s Buyback Math – why 120% of book value is the magic number for Berkshire

In 2012 Warren Buffett indicated he would buyback Berkshire Hathaway (BRK.A) stock up to 120% of its book value, but have you wondered why 120% is the right yardstick and not 110% or 130%? There have been a few posts explaining why 120% might sound reasonable premised on assumptions around estimated book growth and future multiples, however these arguments are unconvincing in my view.

I believe the ‘magic’ 120% of book value is a simple back-of-the-envelope calculation which makes an adjustment for Berkshires capital structure. Continue reading

Insurance float and intrinsic valuation

Link to PDF document (24 pages)

This is a detailed study of insurance float and its role in the valuation of insurance stocks. Buffett made insurance float famous using it to turn Berkshire into an insurance and investment powerhouse. In doing so he has detailed the importance of float in understanding Berkshires valuation, though much of his teachings around float has been lost outside of Berkshire. However, his process remains highly applicable to mainstream insurance analysis, particularly in the determination of intrinsic value.

The report will explore the application of his principles to Australian insurance companies with a focus on successful valuation and stock-picking. Readers will learn why conventional valuation techniques can be flawed and how float-based valuation can be used within a value investing framework. The key issues I cover include: Continue reading