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FairFax Financial: Intrinsic Value Exceeds Market Value

July 14, 2014 | About:
cody56

cody56

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1. Company

Fairfax Financial ( FRFHF )(FFH) is a financial insurance holding company that engages in property, casualty, life insurance, reinsurance, investment management and insurance claims management. Since it was taken over by Prem Watsa ( Trades , Portfolio ) in 1985 the company has compounded book value at 23% and stock price at 19%. Watsa has run the firm very conservatively and it has had rapid growth the last 20 years. The company has average over the last 28 years an average combined ratio of 95%.

Market Cap: $9.81 Billion

Enterprise Value: $13.45 Billion

Insurance Contract Liabilites: $21 Billion

Insurance Premiums Written: $6.05 Billion

Combined Ratio: 92.7%

Debt: $24 Billion

Revenues: $1.68 Billion

Book Value Per Share: $339

Float Per Share: $734

Investment Per Share: $1,047.79

Earnings ($-1.1 billion)

Cash and Cash Equivalent Per Share: $63.58

Pretax Earnings Per Share Excluding Investment Gains: $27.60

Pretax Earnings Per Share Including Investment Gaims:$95.25

Per Share Gains In Investments: $67.65

Free Cash Flow Per Share: $34.74

Dividend Per Share: $10.00

Ticker: ( FRFHF )

1.1 Company History

  • Incorporated in Canada in 1951 as Markel Service of Canada Ltd.
  • The firm specialized in providing trucking insurance in Canada.
  • Markel Services at the time specialized in niche markets.
  • Changed its name to Markel Financial Holdings Ltd. in the 1970s.
  • Prem Watsa (Trades, Portfolio) Founded Hamblin Watsa Investment Counsel Ltd. in 1984 (now wholly owned by Fairfax Financial) met and became friend with Steve Markel.
  • In 1985, Prem Watsa (Trades, Portfolio) took over Markel Financial with the approval and support of Steve Markel.
  • Markel Financial in 1985 was almost bankrupt at the time Watsa took over; he thought all the company needed was a capital injection to survive.
  • He reorganized Markel Financial and renamed it Fairfax Financial.
  • He owns roughly 10% of Fairfax Financial and controls a majority of the voting shares. The company accounts for 99% of his wealth.
  • Legendary value investor John Templeton owned share in the company until he died. He was also a friend and mentor to Prem Watsa (Trades, Portfolio).
  • Since Prem Watsa (Trades, Portfolio) took over the company book value has compounded at 23% every year for the last 28 years.

1.2 Overview of the Business

Fairfax Financial engages in a variety of insurance operations which has allowed the company to use the float from premiums at an annual cost of 2.3% to invest in the stock market or private transactions. Through value investing principles used by Prem Watsa (Trades, Portfolio), he has produces an investment per share valued at $1,073, far above the company's stock price. Fairfax has been a very conservative underwriter that only underwrites insurance when the firm can make a profit. It will not expand its premiums for the sake of expanding the business. The firm has over the last 28 year average a combined ratio of 95% which is below the industry average. All of this makes the company on of the most profitable insurance underwriters in the world.

Board of Directors:

  • Prem Watsa (Trades, Portfolio) (Trades, Portfolio) - Chairman of the board and chief executive officer
  • Brandon W. Sweitzer - Senior fellow, U.S. Chamber of Commerce
  • Johnatan Stevenson - Chairman, Brookfield Funds, Brookfield Asset Management Inc.
  • Alan D. Horn - Chairman, Rogers Communication Inc. and President and CEO Rogers Telecommunications Ltd.
  • Robert J. Gunn - Corporate director
  • Anthony F. Griffiths - Corporate director

Subsidiaries:

Canadian Insurance

  • Northbridge Financial - Based in Toronto, provides property and casualty insurance products throughout the Canadian market. It is one of the largest commercial property and casualty insurers in Canada based on gross premiums written. Net premiums written were Cdn$1.061 billions

US Insurance:

  • Crum & Forster (C&F) - Based in New Jeresy, is a nation-wide provider of property and casualty insurance. The firm writes a broad range of commerical coverage. Net premiums written were US$1.245 billion.
  • Zenith National - Based in Californa, is a provider of workers' compensation insurance business in the U.S. Net premiums written were US$700 million.

Asian Insurance:

  • First Capital - Based in Singapore, writes property and casualty insurance mainly in Singapore. Net premiums written were SGD$186.3 million.
  • Falcon Insurance - Based in Hong Kong, writes property and casualty insurance in niche makets in Hong Kong. Net premiums written were HK$449 million.
  • Pacific Insurance - Based in Malaysia, writes all kinds of classes of general insurance and medical insurance in Malaysia. Net premiums written were SGD$ 186.3 million.

Reinsurance:

  • OdysseyRe - Based in Connecticut, it underwrites treaty, and reinsurance as well as speciality insurance. Net premiums written were US$2.376.9 billion.
  • Advent - Based in the UK, it provides reinsurance and other insurance products throughout the UK. It mainly focuses on specialty property insurance and insurance risks. Net premiums written were US$157 million.
  • Polish Re - Based in Poland, and writes reinsurance in the Central and Eastern European regions. Net premiums written were US$2.376 billion.
  • Group Re - Based in Barbados, and is a third party reinsurer for Fairfax Financial and its other insurance subdiaries.

2. Management

Prem Watsa (Trades, Portfolio) (Trades, Portfolio) has been the CEO and chairman of the company since he took over in 1985. Watsa is known for his honesty as an investor. This shows through in his annual letters to shareholders which are refleshing, enlighting, and a great read for any value investor. The company has kept all of its annual reports going back to 1985.

Executive Officers:

  • Prem Watsa (Trades, Portfolio) - Chairman and Chief Executive Officer
  • Bradley P. Martin - Vice President, Chief Operating Officer and Corporate Secretary
  • John Varnell - Vice President and Chief Financial Officer
  • Peter Clarke - Vice President and Chief Risk Officer
  • Jean Cloutier - Vice President, International Operations
  • David Bonham - Vice President, Financial Reporting
  • Ronald Schokking - Vice President and Treasurer
  • Paul Rivett - Vice President and Chief Legal Officer
  • Eric P. Salsberg - Vice President, Corporate Affairs
  • Hank Edmiston - Vice President, Regulatory Affairs
  • John Cassil - Vice President, Taxation
  • M. Jane Williamson - Vice President

2.2 Executive Compensation

Executive Officers Pay

  • Prem Watsa (Trades, Portfolio) - Annual pay $600,000 and long-term compensation $23,000
  • Paul Rivett - Annual pay $1,407,000 and long-term compensation $188,000
  • David Bonham - Annual pay $660,000 and long-term compensation $48,000
  • Peter Clarke - Annual pay $774,000 and long-term compensation $74,000
  • Eric P. Salsberg - Annual pay $400,000

3. Financial Summary

For fiscal year 2013, the firm's revenues decreased 26% to $5.94 billion, which reflect a net decrease in net premiums earned over 2013. Net losses reflect operating increases of 6% to $1.19 billion. The firm's equity hedges wiped out all of the gains in its portfolio and profits producing a -$31.15 per share in earnings for the year.

For the three months ending in March 2014, revenues increaced 61% to $2.2 billion and net income increased from $146 million to $770 million. Fairfax revenues from US segment increased from $2.2 million to $30 million and other segments increased 69% to $11 million.

Profitability:

Operating Margins 2.45%
Pretax Margins 0.09%
Net Profit Margins 0.82%
Return on Equity -6.86
Return on Assets -1.59
Return on Capital -415.05

Fairfax's investment record:

Common stocks:

  • 5 years - 12.2%
  • 10 years - 19.1%
  • 15 years - 16.1%

Bonds:

  • 5 years - 9.6%
  • 10 years - 9..3%
  • 15 years - 9.4%

Balance Sheet

2013

31/12

2012

31/12

2011

31/12

2010

31/12

Total Current Assets - - - -
Total Assets 35958.8 36941.2 33406.9 31448.1
Cash - - - -
Cash & Equivalents 214.4 212.9 43.5 1540.7
Total Receivables, Net 101.1 233.8 137.9 265.2
Prepaid Expenses - 41.2 34.9 30.2
Property/Plant/Equipment, Total - Net 241.2 259.9 210.8 184.8
Property/Plant/Equipment, Total - Gross 241.2 - - -
Accumulated Depreciation, Total - - - -
Goodwill, Net 851.3 819.8 696.3 572.1
Intangibles, Net 460.5 481.3 418.9 377
Long Term Investments 23844.8 25079.5 23168.3 20687.2
Insurance Receivables 2017 1945.4 1735.4 1476.6
Note Receivable - Long Term 114.1 - - -
Other Long Term Assets, Total 1060.2 648.6 648.3 525.4
Deferred Policy Acquisition Costs 462.4 463.1 415.9 357
Other Assets, Total 6591.8 6755.7 5896.7 5431.9
Total Current Liabilities - - - -
Total Liabilities 27605.7 28120.1 25044.3 22815.5
Accounts Payable - - - -
Payable/Accrued - - - -
Accrued Expenses 510.6 485.4 471 418.5
Policy Liabilities 22354.9 22815.9 20132.1 18533.4
Notes Payable/Short Term Debt 25.8 52.1 1 2.2
Current Port. of LT Debt/Capital Leases - - - -
Other Current liabilities, Total 709.7 859.3 536.1 469.2
Total Long Term Debt 2968.7 2996.5 3017.5 2726.9
Long Term Debt 2968.7 2996.5 3017.5 2726.9
Capital Lease Obligations - - - -
Total Debt 2994.5 3048.6 3018.5 2729.1
Deferred Income Tax - - - -
Minority Interest 107.4 69.2 45.9 41.3
Other Liabilities, Total 928.6 841.7 840.7 624
Total Equity 8353.1 8821.1 8362.6 8632.6
Redeemable Preferred Stock, Total - - - -
Preferred Stock - Non Redeemable, Net 1166.4 1166.4 934.7 934.7
Common Stock, Total 3646.6 3247.1 3247.1 3251.3
Additional Paid-In Capital 50.5 26.8 12.9 3.2
Retained Earnings (Accumulated Deficit) 3551.2 4387.1 4153.8 4394.4
Treasury Stock - Common -140 -121.1 -72.7 -52.4
ESOP Debt Guarantee - - - -
Unrealized Gain (Loss) - - - -
Other Equity, Total 78.4 114.8 86.8 101.4
Total Liabilities & Shareholders' Equity 35958.8 36941.2 33406.9 31448.1
Total Common Shares Outstanding 22 21.04 21.18 21.25
Total Preferred Shares Outstanding 40 40 40 40

Cash Flow Statements

2013

31/12

2012

31/12

2011

31/12

2010

31/12

Period Length: 12 Months 12 Months 12 Months 12 Months
Net Income/Starting Line -564.5 535 47.8 338
Cash From Operating Activities 707.3 1315.7 -1221.5 1039.5
Depreciation/Depletion 104.3 71 59.5 48.5
Amortization - - - -
Deferred Taxes -431.8 15.8 -128.1 -203.5
Non-Cash Items -1916.6 -814.8 -56.4 1222.7
Cash Receipts - - - -
Cash Payments - - - -
Cash Taxes Paid -19.9 69.2 -82.4 218.7
Cash Interest Paid 199.7 187.8 194.4 186.3
Changes in Working Capital 3515.9 1508.7 -1144.3 -366.2
Cash From Investing Activities 214 -291.3 103.8 -708.3
Capital Expenditures -48.1 -71.5 -42.2 -38.6
Other Investing Cash Flow Items, Total 262.1 -219.8 146 -669.7
Cash From Financing Activities -148.7 -464.9 -198.1 773.7
Financing Cash Flow Items 12.7 -15.4 -6.7 -105.9
Total Cash Dividends Paid -266.3 -266.3 -257.4 -232.2
Issuance (Retirement) of Stock, Net 387.1 -50.6 -36 880.4
Issuance (Retirement) of Debt, Net -282.2 -132.6 102 231.4
Foreign Exchange Effects -108.3 46.2 -49.3 13.3
Net Change in Cash 942.9 905.3 -1365.1 1118.2

4. Valuation

Fairfax Financial sells for about 20x its earnings, 1.30x its book value and 5x its pretax earnings which include portfolio gains. If Fairfax sold for 9x to 10x its pretax earnings its would sell for $857.25 to $952.25 per share. The firm has been producing between $50 to $60 per share in profits or gains from its investment portfolio a year. If the firm sold for 1.6x to 1.7x it book value then it would sell for $542.20 to $576.30 per share. The best way to determine the value of an insurance company is to look at its investment per share. Fairfax has over $1,073 per share in investment; that is a ratio of $2.56 in investments to each dollar of cost of its stock. For every dollar of cost the firm is producing nearly $3 in investments. If the company can return just 5% going forward it would be $51 per share and generate 12% return on equity. With its above-averge return on assets, capital and equity, it's very clear that the company has a value range of $952.25 to $1,073 per share. Investing in Fairfax Financial today is like investing in Berkshire Hathaway in the early 1980s.

5. Risk

The risk to potential shareholder and current shareholders is that the company will have massive losses from premiums holders who will need payout from the firm to cover losses. There is also potential losses from the hedges that Mr. Watsa has taken out to protect the company from deflation and market losses. But if Mr. Watsa is wrong an deflation doesn't happen then the firm face masses losses. The firm is currently lossing money on its hedges which are wiping out it profits. If the firm wasn't 100% hedging of its equity portfolio then its would have net an profit of over a billion dollars.

5.1 Outlook

Over the long-term the company will continued to grow its intrinsic value per share. It may not grow at over 20% going forward, but it will grow its stock price and book value above 10%. Mr. Watsa has an record of calling the financial crisis, the asian crisis, and the dot-com bust. I believe that Mr. Watsa and other top managers of Fairfax financial have built one of the best manage and profitable insurance companies in the world. Fairfax has an instrinsic value per share of over $1,000 and over time the firm stock price will reach it, also the firm will continue to grow its intrinsic value per share at above average right going forward. This means that the firms intrinsic value per share will over time exceed 1,000 per share.


Rating: 5.0/5 (7 votes)

Voters:

Comments

FloridaWatcher
FloridaWatcher - 1 month ago

I don't see how you arrive at the intrinsic value. You increase price to book to 1.6 to 1.7, but Fairfax never trades at thsi ratio. Wild assumptions. Put this article on Seeking Alpha and see what kind of responses you get.

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