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Munich Re — My Value Idea Contest Submission

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Jun 16, 2011
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Munich Re – My Value Idea Contest Submission


Munich Re (MUV2.DE, MURGY.US) is the world’s leading reinsurance company. As the name implies, the company headquarters are located in Munich, Germany, though the company does business worldwide. There are more than 47,000 employees with over 13,000 in reinsurance, 33,000 in primary insurance and 800 in asset management.


The three main divisions of Munich Re consist of reinsurance, primary insurance and Munich Health. The group's €193 billion worldwide assets are managed by MEAG.


Almost all of Munich Re’s primary insurance premiums are derived in Europe (99.3%) with nearly all of the reinsurance premiums coming from North America (+- 43%) and Europe (38%). Further exposure comes from Asia, Australasia, Latin America and Africa, as well as the Near and Far East.


The flagship business is the reinsurance property and casualty (P&C) business providing about 60% of gross written premiums


Competitors


Major European reinsurance competitors include Hannover Re (HNR1.DE, Financial), Swiss Re (RUKN.VX, Financial) and SCOR (SCR.PA, Financial). However, Munich Re is easily the largest company compared on both a net asset and written premium basis. Furthermore Munich Re sets itself apart from its competitors by utilizing an insurance/reinsurance model which, in 2009, was split approximately 50/50. Economies of scale also factor as an advantage for Munich Re, as smaller businesses may not get access to lines of business and treaty layers that Munich Re has access too.


It is worth noting that Munich Re outperformed its competitors during the financial crisis.


The Bad and Ugly


Warren Buffett , whom incidentally owns over 10% of MUVR2 shares, likes to purchase shares in solid companies when storm clouds are looming over a business. Currently there are storm clouds aplenty in the European (re)insurance sector. During the start of 2011 Munich Re got stung by a wave of disasters in Japan, Australia and New Zealand. In Q1 the company lost €948 million alone though the company still expects to record a profit for the year, according to its first quarter 2011 press release. With the onset of the US hurricane season this loss figure could rise further resulting in a loss figure for the year. CFO Jorg Schneider said that Munich Re had "the most difficult start to a financial year we have experienced for a long time."


Recently, industry quotes for disaster protection in Florida varied by as much as 15% below the average and 16% over the average as opposed to the usual variance of around 3%. This fact suggests that (re)insurers don’t really know the value of their capital. It also suggests that some reinsurers are raising their rates, which would lead to a boost of returns at the expense of primary insurers and their customers.


Facts also came to light over the last few months that the company rewarded top salesmen with foreign trips on which they were rewarded by the services of prostitutes. Apparently this type of reward is not too uncommon in German business circles. The organizer of such escapades was a manager in the company’s ERGO division and he has left the company since organizing these parties.


A Positive Side


However, the positive side for the patient investor is that the above problems are temporary which has led to a weakening of the share price. Volatility abounds aplenty in Munich Re’s share price action and for this reason the shares have been a favorite trading share of mine for around the last two years. I have been purchasing shares at around the €100 level and selling out north of €110. Currently, at time of writing, the shares are trading at around the €100 level having fallen from the €125 level reached at the end of February last.


A New Image


Munich Re introduced a new insurance brand in early 2010. There was absolutely no need for another insurance brand in the market however there was a need for an agent to listen to its clients. After surveying over 6,000 clients, in order to find out how, and what, clients think of insurance companies, Munich Re set up the ERGO division replacing the Hamburg-Mannheimer, Victoria and KarstadtQuelle brands.


The DKV (health insurance), ERV (travel insurance) and DAS (legal expenses insurance) brands remain unchanged as these brands target specialist lines of business. Non-life insurers Hamburg-Mannheimer, Victoria and DAS have been merged and Victoria’s life operations are closed for new business.


Through Ergo, now Germany’s second largest primary insurance group, the company hopes to increase its share of primary business outside Germany through a Bancassurance partnership with UniCredit S.p.a. which currently serves Germany, Austria and Poland. Central and Eastern Europe are the first targets of expansion.


As with lines of credit in the banking industry, and perhaps even more so (as banks have non-interest income), the (re)insurance industry relies on writing profitable business. During 2009/2010 MUV2 disposed of weakly priced business in its reinsurance division resulting in lower premiums. However a short term decline due to trimming exposure is more favorable than running weak exposure for larger declines in the future. Management in this regard is very shrewd.


Exposure trimming occurred in the motor business of Germany, China and Eastern Europe as well as credit reinsurance and US casualty business.


Management


Nikolaus von Bomhard is Munich Re CEO. Von Bomhard joined Munich Re in 1985, after earning a doctorate in law, and was appointed CEO in 2000. He is 55 years old.


Munich Re has eight other board members each with considerable experience in the industry. All members except for two have at least five years experience in their current role.


Risks


Certainly there are risks, apart from the usual insurance underwriting risks, etc., when investing in Munich Re.


First on the list are the claims pending from the disasters earlier in the year especially those from Japan. If claims are higher than anticipated it will leave Munich Re with a smaller capital buffer which in turn would offer lower protection for other possible cats later in the year. This in turn could threaten solvency if a perfect storm of mega cats arrive. If this scenario occurs it will not only be Munich Re that will be in trouble but rather the whole (re)insurance sector will be in turmoil. Currently only preliminary loss estimates have been given but the final numbers are still uncertain.


A possible sharp rise in longer term bond yields could also spell trouble for Munich Re as this would lead to market-market losses on the company’s fixed income portfolio. Risks from lower grade government bonds, such as from the peripheral European countries, is said to be manageable as exposure is fairly limited.


It is likely that the US will see a higher rate of inflation than Europe. This plays into Munich Re’s hands as US bond exposure is less than 10% of total bond exposure. German and other European bond exposure accounts for over 30% of total bond exposure. Of this amount around a third is comprised of PIIGS exposure.


Germany’s (re)insurers are seeking an exemption to rules governing their holdings of Greek government bonds. The (re)insurers are hoping to avoid a forced sale of these bonds since the bonds were downgraded by credit rating agencies. Munich Re holds around €1.1 billion of Greek government debt.


New insurance risk-capital rules, named Solvency II, are due to come into effect in 2013.


Valuation


We must understand that Munich Re is the strongest capitalised reinsurer in the business and it is this strength that allows the company to forecast a profit for the year after embarking on a terrible start for 2011.


At the time of writing, Munich Re’s market capitalization is €18.2 billion, which is an 11% discount compared to the equity figure found in the 2011 first quarter report of €20.5 million. Historically it is rare for Munich Re to trade at a discount to book value.


2011 will be deemed an exceptional year for Munich Re, so a valuation method based on a multiple is not appropriate. At a push we could take normalised earnings of 15 Euro on a conservative multiple of 10 in order to achieve a target price of 150 Euro. Other earnings-based methods are not appropriate either, unless they are based on historical average figures being projected forwards, as the resultant figure will be wide of the mark due to low exceptional earnings on a large equity base.


Looking at the dividend over the last 10 years we can see that in 2000 the payout was €1.25 per share. In 2010 the payout was €6.25 per share with a slightly larger amount of shares in issue in 2010. Note that dividends weren’t increased every year but in some years they were maintained. The dividend was never lowered in any year. An estimate based on the above could see another dividend payout for 2011 of €6.25.


Combine this dividend yield of 5.5%-6%, depending on the price at which the shares were purchased, with share buyback schemes the company has embarked on, and the annual return to shareholders exceeds 10% excluding any capital gains.


The buyback programme for the year 2011 has been scaled back due to the poor start resulting from the fore-mentioned tragedies.


The Oracle of Omaha himself, Warren Buffett, bought his initial Munich Re shares at much higher prices (I estimate the most he paid was around €125-130) so at €100 the shares must be good value. Indeed, Mr. Buffett holds 100,000 Munich Re shares in his personal portfolio as well as a significant holding through Berkshire Hathaway. The Oracle has mentioned that he would be happy to buy more shares. At current prices I would bet that he is adding.


Also, when Buffett talks about earnings volatility he is talking about (re)insurance companies. The current year for Munich Re is a prime example of earnings volatility. If you buy now, or lower, and sell when the sun is shining you are sure to make a profit, although it may take a little patience.


Tweedy Browne and Blackrock have both recently added Munich Re stock to their portfolios.


The best method of valuation for Munich Re is without doubt a float based valuation.


I calculate it as follows: add float to tangible equity which gives Euro 61.5bn. Market capitalisation equals around Euro 18.5bn. This figure gives over 3X upside based on float valuation. No doubt a declining reinsurance market and taxation on investment returns accounts for much of this gap. However it still looks like the shares are significantly undervalued. JP Morgan's target price of Euro 145 is realistic I think though I would love to see how they derived at that figure.


Perhaps the current storm clouds will darken further allowing entry, or an addition, at less than €100 per share.


Please see page two, in the link below, of the 2010 annual report for a review of the consolidated figures as well as divisional figures: http://www.munichre.com/publications/302-06773_en.pdf


Outlook


Reinsurance gross written premiums should come in between €25 billion and €26 billion in 2011. Likewise total primary insurance premiums should total approximately €17.5 billion. Munich Health is expected to write €6 billion of gross premiums. Total consolidated premiums, if exchange rates stay stable, should equal between €47-49 billion.


A return of just under 4% is expected from Munich Re’s investment portfolio.


A profit is expected for 2011 even if further catastrophic losses occur. Any major cat losses in the property-casualty reinsurance division can be partly counter balanced by the life reinsurance, primary insurance and Munich Health divisions.


Munich Re sees its medium to long term business opportunities as positive.


Recent News


Though the company has not named any specific targets Munich Re is looking for US acquisitions. Torsten Jeworrek, board member and CEO of Munich Re’s reinsurance division, noted that the company is disproportionally represented in the US. Furthermore, Jeworrek sees potential in Asia and Latin America.


JP Morgan (JPM, Financial) has a price target of €145 for Munich Re: http://www.aktien-meldungen.de/Analysen/Kaufen/JPMorgan-belaesst-Munich-Re-auf-Overweight-Ziel-145-Euro-9652013


Calendar


30 June – London Roadshow


20 July – Munich Re Capital Markets Day 2011, New York


4 August - Interim results till June 30, 2011, and half-year press conference


Conclusion


Munich Re is not the cheapest stock that you’ll find on the markets. However, at the current price of around €100 the stock is worth buying for a good trading opportunity, a large dividend and a recommencement of the share buyback program once current troubles are behind the company.


If Warren Buffett holds Munich Re in his personal portfolio so, perhaps, should you.


Munich Re is a solid long term stock which is definitely suitable for a "widow and orphan" portfolio.


Usually I would make an alternative recommendation. A prime example is the La Farge article which I wrote for "Analysis on Demand." I analyzed the positives and negatives then I valued the company. I knew that West China Cement (HK:2233) was a superior company in many aspects so I recommended not purchasing La Farge but buying West China Cement stock.


However, I don’t see a listed substitute for Munich Re. The company is definitely the market leader with a strong capitalization and can take advantage of this fact to pull in more business, especially as smaller rivals go to the wall. Perhaps a private reinsurer, on par with Munich Re, would be General Re which made a nice profit in first quarter 2011 due to dividends from subsidiaries.


However, one must purchase Berkshire Hathaway stock to gain exposure to General Re. As most investors know you will also create exposure to many other businesses when you buy Berkshire stock so for pure reinsurance exposure Berkshire is not an option.


Further Reading


Apart from the company’s website found here:

http://www.munichre.com/en/homepage/default.aspx


There are also a number of excellent Much Re articles by GuruFocus contributor Juan Ramon Velasco Barros as detailed below:


Juan’s reasons for buying Munich Re: http://www.gurufocus.com/news/133888/i-initiated-a-position-in-munich-re-at-almost-the-same-price-as-berkshire


How does inflation affect (re)insurers: http://investing.kuchita.com/2011/05/26/how-does-inflation-affect-insurers/


Disclosure: I own Munch Re stock and plan to purchase more as the price falls.
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