Economy | in search of Value

Mysterious Silence from Cott Corporation

January 15, 2009 — John Appel

Cott Corp. (COT) should be in crisis-mode: it is overleveraged, underperforming, and lacking both a permanent CEO and a compelling growth strategy. With an activist investor and some seasoned executives on the Board to shake things up, one would expect dramatic action, but it seems like little has been accomplished to date. Have they really been that ineffective, or have they perhaps been distracted? Shareholders need to know what is happening. If there is any material news, we should not have to wait for the next earnings call.

Last year, things began to look encouraging when:

the company parted ways with its CEO and initiated a search for a successor;
activist investor Crescendo Partners purchased an 8% stake and installed four new directors; and
the company embarked on a turnaround plan targeting over $40 million of cash flow improvement (there was still no real growth strategy, but presumably that would come with a CEO).

With accomplished investors and executives on Cott’s board (although only one has beverage experience), one would have expected rapid change. Instead, we have had more of the same:

revenue and EBITDA still trended downward as of September 27th, as Coke and Pepsi promoted aggressively, Wal-Mart cut-back shelf space, and initial savings from the turnaround plan were offset by other costs;
net debt was unchanged in September versus June;
the Interim CEO has discussed the need to invest in growth, but has not outlined a strategy; and
there is still no permanent CEO.

On the last earnings call on November 6th, the company’s Interim CEO, David Gibbons, said that he expected a decision on a new, permanent CEO by year-end. The end of the year has passed, yet there is no news.

COT 12 Mo. Stock Prices This is frustrating, and begs the question of whether there is something else going on at Cott. Crescendo’s CEO, Eric Rosenfeld, joined Cott’s board as Lead Independent Director, and I doubt that he would sit idle while things drag on. Cott hired a respected search firm to help identify a CEO, and Crescendo also had at least one candidate lined up. It is possible that the board has not been able to agree on a candidate. It is also possible that they had a big fish on the line but that it got away at the last minute. However, it is also possible that the board slowed down the process to deal with something else. This is sheer speculation, but one reason to delay the process, and the only good reason I can think of, would be a potential sale of the company.

Has a Potential Buyer Heeded My Call?

Last October, I wrote an article entitled, “Cott Corp. – Could go Far, But Somebody Needs to Grab the Wheel.” The article included this call to action directed at potential buyers: “Now is the time for action by an industry acquirer, or a private equity group with the ability to capitalize Cott properly.” I said that the most likely strategic buyers are National Beverage (FIZZ), Dr Pepper Snapple Group (DPS), and Polar Beverages.

My article seemed to create a stir at Cott and in other beverage circles. The morning that the article was posted on Seeking Alpha, a Cott executive contacted me and asked about my background and affiliations, and how I came to know so much about the company. But he also gave me positive feedback on the article. I later learned from reliable sources that each of Cott’s directors had received the article. I also heard from several industry executives who thought that my article was right on target. I had assumed that the kudos had to do with my emphasis on getting back to basics and hiring an effective CEO, but perhaps there was more to the feedback….

If the Company Were Sold, What Would Be a Fair Price?

Absent an acquisition, my estimate of Cott’s fair value is $1.00-$1.50 per share. I get to this figure by applying discounted market multiples to my estimates of 2008 and 2009 EBITDA. I get to the same figure through a discounted cash flow analysis that factors in a turnaround over the next three years (but shows little top-line growth). This value estimate is higher than price targets from some reputable sell-side analysts. For example, an analyst at a well-known global bank (which also owned over 5% of Cott’s common shares as of the last proxy statement) had a price target of $1.00 per share as of this writing, which was lowered from $1.25 per share in November (he also used EBITDA multiples and a DCF analysis). In calculating my fair value estimate, I discount my EBITDA multiples, and add a risk premium to my DCF discount rate[1], because of two significant risks the company faces: high leverage and customer concentration. Absent these risks, my valuation would be in the range of $2.00-$2.50 per share.

A strategic acquirer that could realize synergies might value the company in the range of about $2.50 to $3.50 per share. I have done enough fairness opinions in my career to feel comfortable that Cott’s board would be advised that such a price was fair. The chart below shows the implied enterprise value and EBITDA multiples for various share prices.

The above fair value estimates and estimates of an acquisition price would all be much higher if Cott had better growth prospects.

The Board is Unlikely to Accept an Offer Today

While $2.50 to $3.50 per share may be a fair value, it is unlikely that Cott’s board members would agree.

Following its purchase of 5.9 million Cott common shares last year, Crescendo Partners had four new directors named to what is now an 11-person board. These new directors and at least three others have a strong incentive to block a change of control.[2] Thus, a firm that owns only 8% of the company’s common shares is effectively in a position to block Board approval of any transaction it does not like.

Crescendo purchased its shares at an average price of $2.84 per share (see 13D filing). It is clear in hindsight that things at Cott were worse than they appeared last spring when these purchases were made, and that Crescendo overpaid. While Crescendo might be happy just to get its investment back, it is much more likely that they would want to put in a new CEO and let that person attempt to build value for a few years before selling.

A Long and Bumpy Road Ahead

If an investor or competitor does not (or cannot) “grab the wheel” by purchasing Cott, and shareholders have to rely on a new CEO to navigate the company out of its current situation, we should be prepared for a difficult journey. The problems faced by the company are not easily fixed. Yes, retailers should now have a greater interest in building their private label programs, but Cott’s area of expertise – carbonated soft drinks – is going to be a tough place to find growth. Cott knows this and is expanding into other areas, such as water and noncarbonated drinks, but these are markets in which Cott has numerous competitors with ample capabilities.

COT Leverage Ratios Cott’s high leverage means that it cannot afford to make a mistake. The chart to the right shows Cott’s net debt as of September 27th, and how this compares to various measures of cash flow.

Given the difficulty of executing a turnaround, I would not expect lenders to have patience in the event of a default. If things go South, I believe there will be little left for common shareholders. A savvy investor would be able to purchase Cott’s 8% Senior Subordinated Notes for pennies on the dollar in that scenario and end up owning the company through a Chapter 11 reorganization.

Even if management executes well, it will take a long time to deleverage the business. Subtracting interest and capital expenditures from EBITDA leaves only about $20-$30 million per year to pay down debt. If management decides to try to grow its way to success instead of cutting costs to the bone – which is probably the best strategy for the long term – there will be even less cash flow available to repay debt until the growth starts to generate profits.

A risk that may never go away is the company’s dependence on Wal-Mart (WMT). Wal-Mart represents 36% of Cott’s sales, and I believe it has been Cott’s cash cow. I can say from experience as a private equity investor who has looked at thousands of companies, that when a customer represents nearly 40% of sales it often represents well over 50% of profits (sometimes over 100%), even if that customer is known for driving a hard bargain. The substantial benefits of long and efficient production runs, along with freight efficiencies, typically more than offset lower unit prices.

I warned in my last article that Cott’s customers might be concerned about the company’s viability. The customer I had in mind was Wal-Mart. Wal-Mart’s reduction of Cott’s shelf space last year may have been the first step toward reducing its exposure to Cott. The next logical step would be to split the business, or maybe even go all the way and switch suppliers (an extreme event that I would like to think is improbable). Analysts have asked Cott about its relationship with Wal-Mart on recent earnings calls, and management has responded with assurance that the relationship is fine. I do not have reason to doubt management’s statements, but I remain concerned about this risk.

Given Wal-Mart’s share of U.S. beverage sales, Cott should not address this risk by reducing the percentage of its sales that go to Wal-Mart. The better approach is to do what it takes to make sure that Wal-Mart is satisfied – not just with the terms of its relationship but also with Cott’s viability and stability as a long-term partner. In a normal capital markets environment, I would recommend an equity infusion to fund growth and reduce debt. In the current environment, meaningful deleveraging and growth capital would almost certainly require a change of control.

Time for Action

Cott is vulnerable, and one should not assume that customers and competitors are sitting still. The Interim CEO seems capable but has no beverage experience. This is no time for the company to drag its feet, and no time to keep shareholders in the dark. Cott’s board should let us know what is going on, and, more importantly, DO something!

The company should also ensure that its board is structured to encourage decisions that are fair. Putting an 8% shareholder in a position to call the shots on a change of control transaction does not strike me as consistent with board members’ fiduciary obligation to look out for all shareholders. If Cott is ever presented with the opportunity to enter into discussions with a potential buyer, the board should form a special committee, made up of truly independent directors, to make key decisions. And shareholders should be informed.

Financial Summary

A summary of the company’s historical financial performance and my projections for 2008 and 2009 follows below. As previously discussed, I assume that it takes several years to achieve management’s turnaround objectives. I assume that revenue growth is flat in 2009 (i.e., that price increases equally offset volume reductions), and that gross margin improvements from prices increases are offset next year by unfavorable variances from a stronger dollar. I include $20 million of cost savings from the water project, but assume that G&A savings are offset by investments to maintain, and eventually grow, the business – mainly “market development funds.”

COT Projections (JGA)

Footnotes:

[1] This may offend CAPM purists, but it is a lot easier than calculating an unlevered beta.

[2] Cott Corp.’s Board of Directors is comprised of Chairman David Gibbons, George Burnett, Stephen Halperin, Betty Jane Hess, Philip Livingston, Andrew Prozes, Graham Savage, and four new directors appointed in connection with Cott’s agreement with Crescendo: Eric Rosenfeld, Mark Benadiba, Mario Pilozzi, and Greg Monahan. Their bios are on Cott’s website. Other than the Crescendo parties (Rosenfeld and Monahan), those with the least incentive to approve a change of control would appear to be:

David Gibbons. He makes $725,000 per year plus incentive awards as Cott’s Interim CEO, and approximately $100,000 more per year as a director. He would lose this income upon a change of control.
Stephen Halperin. He is the brother of the company’s former chief legal counsel, Mark Halperin, and has been on the board since 1992. Cott’s most recent Proxy Statement discloses that his firm provides services to Cott “on a regular basis,” which services would likely be discontinued after a change of control.
Philip Livingston. He earns over $100,000 per year as a Cott director. His role on Cott’s Audit Committee is featured prominently on his personal website.
Mario Pilozzi. He was likely brought on because his former role as CEO of Wal-Mart Canada may leave him with important ties to Wal-Mart. These same ties would create a bias toward Cott remaining an independent company, which would benefit Wal-Mart.
Mark Benadiba. Mark probably would like to be CEO of Cott himself. As long as this remains a possibility, he will have a bias against a transaction that would take that possibility away.

(Disclosure: The author is long COT common stock)

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Posted in Consumer, Food & Beverage, Small-Micro Cap, Special Situation. Tags: activist investor, Beverage, business, Coca-Cola, Cott, Economy, PepsiCo, private label, restructuring. 3 Comments »

Private Equity Group Takes Stake in Jamba

January 13, 2009 — John Appel

CIC Advantage Holdings LLC, an affiliate of Dallas-based CIC Partners, has acquired a 5.6% stake in Jamba, Inc. (JMBA) according to a recent 13D filing. CIC Advantage paid an average price of $0.86 per share for its 3,077,900 shares.

JMBA stock chart This is CIC Advantage’s second investment to date. The first was a $12 million growth capital investment in Red Mango, Inc., a 30-unit frozen yogurt chain (see press release).

CIC Advantage is run by John Antioco, former Chairman and CEO of Blockbuster, Inc. and an Operating Partner at CIC Partners. His prior restaurant experience includes Taco Bell and Main Street Restaurant Group (the largest TGI Friday’s franchisee and a former CIC portfolio company).

The other directors of CIC Advantage include Michael Rawlings, former President of Pizza Hut; Fouad Bashour, a former associate at The Boston Consulting Group; Chuck Rawley, former Chief Development Officer of Yum! Brands and former President and COO of KFC; and Roger Enrico, former Chairman and CEO of PepsiCo.

The 13D filing states as the Purpose of the Transaction:

The Reporting Persons purchased the shares of the Common Shares based on the Reporting Persons’ belief that the Common Shares at current market prices are undervalued and represent an attractive investment opportunity. Depending upon overall market and general economic conditions, other investment opportunities available to the Reporting Persons, the market prices of the Common Shares and/or other equity, debt or other securities, notes or instruments of the Issuer (collectively, the “Securities”), the business affairs and financial condition of the Issuer and other factors deemed relevant to the Reporting Persons, the Reporting Persons may endeavor to increase or decrease their position in the Issuer through, among other things, the purchase or sale of Securities in the open market or in private transactions, including the purchase of Securities through a tender offer or otherwise, on such terms and at such times as the Reporting Persons may deem advisable.

This appears to be a toehold purchase, made in anticipation of a proposal to invest in or acquire the company. According to the CIC Partners website, CIC Partners and John Antioco, through CIC Advantage, “seek to provide equity to companies and management teams in support of unit growth, acquisitions, recapitalizations, and turnarounds of multi-unit retail and restaurant concepts and are open to both majority and minority investments.”

CIC Advantage could find JMBA attractive as a stand-alone company, but another potential strategy would be for CIC to recapitalize JMBA through an equity infusion, or acquire it outright, and use the company as a platform to roll up other healthy lifestyle concepts such as Red Mango.

Whether their strategy involves other brands or is focused on JMBA alone, CIC Advantage seems like a terrific partner for JMBA. I hope that this investment leads to a larger transaction. In the meantime, I maintain my $1.30 per share price target, as noted in my December 18th article, “Jamba Juice Should Bear Fruit by Mid-2009.”

(Disclosure: The author is long JMBA)

Posted in Consumer, Food & Beverage, Restaurants, Retail, Small-Micro Cap, Special Situation. Tags: Antioco, business, Economy, Enrico, jamba, PepsiCo, Red Mango, Restaurants, smoothie. Leave a Comment »

AIG’s Bond Sale is No Cause to Celebrate

December 17, 2008 — John Appel

The latest installment of the American International Group (AIG) “Bailout” is not the good news that one might imagine from reading AIG’s press release. It does not provide as much financing as originally anticipated. More importantly, it is a reminder that, so far, the U.S. government has done much more to minimize losses for AIG’s counterparties than to maximize value for AIG.

AIG and the Federal Reserve Bank of New York announced on Tuesday that Maiden Lane II, an entity owned and controlled by the NY Fed, has purchased nearly $40 billion of mortgage-backed securities (RMBS) from AIG subsidiaries. This was part of the revised U.S. government bailout announced on November 10th. I described these arrangements in my article last week entitled, “AIG’s Bailout Needs a Bailout: A $150 Billion Problem.”

Edward M. Liddy, AIG Chairman and Chief Executive Officer, said: “AIG’s highest priority is the full repayment of the federal loan facility with interest. The creation and launch of this financing entity will eliminate the liquidity issues associated with AIG’s U.S. securities lending program, which will facilitate our repayment plan. Although we have more work ahead of us, this is an important step forward. We appreciate the support of the Federal Reserve Bank of New York in implementing this transaction.” This seems to imply that this ‘financing entity’ is a new development that frees up AIG capital that otherwise would have gone to satisfy securities lending payables.

While the transaction is a means of financing AIG’s securities lending payables, it is part of the bailout plan and does not provide any capital beyond that anticipated in the bailout. In fact, it provides somewhat less. The illustration in AIG’s November 10th 10-Q¹ filing shows a purchase price of $23.5 billion, based on fair market values on September 30th. The actual transaction was based on lower values as of October 31st, and the purchase price was $19.8 billion instead of $23.5 billion.

In my previous analysis, I assumed, based on the 10-Q disclosure, that $23.5 billion would cover substantially all of the securities lending payables, and the financing would provide $22.5 billion, leaving $1 billion to be paid by AIG. In the final deal, these payables required $24.9 billion – the $19.8 billion of sale proceeds plus a $5.1 billion capital contribution from AIG. In other words, the final deal required an additional $4.1 billion from AIG.

The real bad news here is not that the value of these RMBS securities fell by $3.7 billion, or 15.7%, in one month; nor is it that AIG had to contribute $4.1 billion more to wind down its securities lending business. The bad news is that until the deal was finalized, the NY Fed had the ability to make it a more effective tool for saving AIG, and now that chance is gone.

The NY Fed has purchased a portfolio of mortgage-backed securities for 50 cents on the dollar. This price is more reflective of the lack of liquidity in the market than default rates. It is likely that a price of around 80% of par would have more closely approximated the ultimate recovery if the securities were held to maturity.² The NY Fed’s agreement to share a small portion³ of the gains with AIG after its loan to Maiden Lane II is repaid does little to help things today. This should turn out to be a nice investment for taxpayers.

While some of the legal details have yet to be ironed out, it is clear that the U.S. government controls AIG. The U.S. government can choose to maximize the long-term value of AIG’s most important assets – its reputation and its people – or it can focus on the salvage value of its financial assets. Its actions to date indicate that it is focused more on the latter than the former.

So far, the U.S. government has made sure that banks, investment banks and other parties to AIG’s credit default swaps and securities lending agreements are made whole, even though these parties do not have the most senior rights as creditors. Now that a partial list of the beneficiaries of these transactions has been made public, it is becoming clear that if these institutions had been forced to bear some loss as part of a negotiated deal outside of bankruptcy, the financial system would not have buckled. The U.S. government made a policy decision to help certain members of the financial system that had transacted business with AIG, and has handed the bill to AIG. Whether or not the policy decison is justified, forcing AIG to bear the entire cost is not.

Nearly all of the $170+ billion bailout has gone to fund losses on securities that are no longer on AIG’s balance sheet and have nothing to do with AIG’s go-forward business, so nearly all of the bailout funding arguably should have been funded off-balance sheet. Instead, only about $50 billion is being funded off-balance sheet through Maiden Lanes II and III.

As a result, AIG is saddled with over $270 billion of debt and high dividend preferred stock, compared to under $150 billion in 2006. As I explained in my analysis last week, the $270 billion needs to come down to around $120 billion before AIG’s balance sheet will truly be stabilized, and deserving of its ratings. The plan is to achieve this through asset sales, but this is fallacy. The current value of the assets targeted for sale is probably less than half of the amount needed. Besides, the operating income from the targeted businesses⁴ may represent nearly half of AIG’s total normalized operating income, so if they were sold, the amount of debt that the remaining businesses could support would be far less than $120 billion.

AIG can limp along on “life support” for several years, since interest and dividends on $100 billion of the financing can just accrue instead of being paid in cash, but this just adds to the bill down the road.

The industry and AIG’s employees know that AIG’s current situation is not sustainable, and it is starting to show. AIG disclosed in its 10-Q that its business is being negatively impacted by its financial instability. And the company’s loss of senior executive Kevin Kelly to a competitor last week is just one example of what will happen to AIG’s executive ranks if things are not stabilized soon.

It is not clear if the U.S. Government cares about this, or if the intent is to break up the business, run-off the assets, and hope to recover at least the debt portion of the bailout funds. It is not too late to choose the growth strategy over the wind-down strategy, but if growth is indeed the goal, the current course must change quickly.

Footnotes:

¹ Please see the “Subsequent Events” section of AIG’s Q3 form 10-Q filed on November 10, 2008 (page 45).
² As of September 30th, AIG’s RMBS included $14 billion each of Alt-A and subprime loans (the bulk of the rest was Agency and Prime). In October, 18.2% of all U.S. subprime loans were in foreclosure or REO, and another 10.4% were 90+ days past due (download data). Of all Alt-A loans, 9.3% were in foreclosure or REO and 4.8% were 90+ days past due (download data). Assuming that all of these end up in default and that the net recovery is zero, the total loss averages 21.3% between the Alt-A and subprime. The bulk of the RMBS were rated AAA, so they probably had about 10% subordination below them. Thus, assuming the securities sold to the NY Fed were evenly divided between Alt-A and subprime, the loss would be roughly (21.3%-10%)/90%, or 12.6%. This implies that a price of about 85% of par, or perhaps as low as 80% to allow a cushion, would have been a reasonable figure for the NY Fed to pay if the goal were to maximize the support of AIG while minimizing the loss to taxpayers. Instead, the NY Fed took advantage of the current dysfunction in the capital markets to buy the RMBS at a low price (for a scholarly article on how current market prices for mortgage-backed securities are below fundamental values, click here).
³ After the NY Fed loan is repaid, the first $1 billion (plus interest) of gains is paid to AIG subsidiaries, then the remainder is split 5/6 to the NY Fed and 1/6 to AIG subsidiaries.
⁴ Please see “Segment Information” on page 149 of AIG’s 2007 form 10-K for the operating income of AIG’s Life and Retirement Services businesses and aircraft leasing business.

(Disclosure: The author has no positions in AIG.)

Posted in Financial Services, Insurance, Mid-Large Cap, Special Situation. Tags: AIG, AIGFP, Bailout, bankruptcy, business, CDO, CDS, CMBS, Credit Default Swaps, Economy, Insurance, Reinsurance, restructuring, Subprime, TARP. 2 Comments »

Reinsurer Stocks: A Fear-Driven Market Creates Opportunity

November 25, 2008 — John Appel

Catastrophes both natural and man-made have been hitting reinsurance companies, but the outlook is good. Shares of all the reinsurance companies were pummeled in October, with the combination of Hurricanes Ike and Gustav hitting underwriting profits while the capital markets carved a mark-to-market chunk out of investment portfolios. Things seemed to improve around Halloween and into November, as signs of “hardening” premium rates began to emerge. But shares have recently retested their lows as the dysfunctional capital markets – especially for mortgage- and asset-backed securities – overshadow improving fundamentals for the group. This has created opportunity for the intrepid value investor.

* Does not include AIG, BRK, and XL.

I evaluated a dozen reinsurers based on factors including:

underwriting and overall profitability;

historical and expected premium growth;

financial strength ratings;

fixed income portfolio make-up, duration and average ratings;

financial leverage; and

capital adequacy.

Table 1 lists these companies in order of total capital, along with relevant market value multiples, some key performance metrics, and my per-share valuation of each company based on fundamental analysis (except for AIG (AIG) and Berkshire Hathaway (BRK-A), which I include for comparison but don’t value). Table 2 provides information on their investment portfolio quality. Table 3 shows debt-to-capital ratios and a ratio I use a rough indication of capital adequacy: the ratio of cash and investments to loss reserves.

**Table 1 – Reinsurer Market Multiples, Key Metrics & Target Price**

* Medians exclude Berkshire Hathaway and AIG. See endnotes for an explanation of terms and calculations.

The companies that trade (as of 11/24/08) at the steepest discount to my estimated “fundamental” values are ACE Limited (ACE), Axis Capital (AXS), PartnerRe (PRE), Validus (VR), and XL Capital (XL). Below is a brief discussion of each company:

**Table 2 – Fixed Income Portfolio Quality**

* Medians exclude Berkshire Hathaway and AIG. See endnotes for an explanation of terms and calculations.

ACE Limited, founded in 1985, is a Zurich-based leading global property & casualty, life, and accident & health insurance company and reinsurance company with operations in more than 50 countries. Its ACE Tempest reinsurance operations are well respected but comprise less than 10% of ACE’s consolidated net written premiums. Reinsurance net written premiums are down over 22% YTD, but its prospects for growth are good, as ACE has the scale and reputation to capture significant business from AIG at January renewals. ACE has the best YTD combined ratio of the group. The quality of its fixed income portfolio is about average for the group, and its make-up and duration are consistent with its insurance business mix. As of 9/30, ACE had $5.5 billion of asset-backed securities (“ABS“) and non-agency mortgage-backed securities (“MBS“) in its portfolio, including $2.3 billion of commercial mortgage-backed securities (“CMBS“). Given that spreads have recently skyrocketed for these securities (see chart, below), ACE is likely to report more unrealized investment losses in the fourth quarter (a 100 basis point yield increase equates to a +/-350 bp price reduction on a portfolio with a 3.8 year duration, or over $1 billion on ACE’s $36 billion fixed income portfolio). These unrealized losses should have little real impact because ACE should not need to sell its structured securities (at least not in this market), but it seems that investors need little incentive to punish a stock these days, so value investors should see further buying opportunities.

CMBS Spreads

click image to enlarge
Axis Capital is a Bermuda-based specialty P&C insurer and reinsurer, founded in November 2001. Reinsurance is the majority of its business. Property, professional lines and catastrophe are its largest business lines, representing 26%, 21% and 16% of gross premiums written. These businesses should all see firming rates in 2009. Its fixed income portfolio is higher rated on average than most at AA+ and the average duration is shorter than most at 2.9 years. It includes $1.7 billion of ABS and non-agency MBS (including $860MM CMBS). The relatively short portfolio duration means that an increase in credit spreads not only will have less effect, but also is more likely to be offset by yield curve changes. One potential portfolio risk is the $636 million of hedge funds, credit funds and CLO equity tranches, for which marks vs. cost are not disclosed. However this exposure is only 13% of book value. AXS is very well capitalized relative to its current book of business, and its debt-to-capital is the lowest of the group at only 9%, so the company is quite well positioned to grow. S&P gives it an “A” rating but a “positive” outlook – the only “positive” for the group. Its management team is strong and seasoned, and its level of capitalization and other metrics are more representative of an A+ company, so it is likely that its relatively short operating history has been the only thing holding it back from an A+.
PartnerRe, based in Bermuda, was founded in 1993 and is the 10th largest global reinsurer, with lines of business that are well diversified by risk category and geography. Premium growth YTD was driven by opportunistic business in the agriculture sector; other lines of business declined consistent with the group (when adjusted for one-time items). A principal reason for the decline was greater risk retention by ceding insurers. With insurer balance sheets constrained and little ability to reload in the current capital markets environment, risk retention by primary insurers is less likely to impact growth in the next year or two. The company is well positioned with its “AA-” S&P rating. PRE’s combined ratio was an attractive 91.4% despite hurricane losses in Q3, which speaks to the company’s underwriting discipline and ability to generate profitable growth. PRE’s investment portfolio has only $825MM of ABS and non-agency MBS, although widening credit spreads on its $1.3 billion of finance sector corporate bonds (banks – $600MM) will also have an impact. Unrealized losses will hit earnings, not just comprehensive income, because PRE elected “fair value” treatment under FAS 159 this year (ACE, AXS, VR and XL continue to flow unrealized losses through comprehensive income, except that ACE made the FAS 159 election for its equity securities).
Validus Holdings, based in Bermuda, was formed in December 2005. Through Validus Re, it is a leading writer of property catastrophe insurance and also writes marine, energy and other specialty, short-tail lines. VR writes direct insurance through Lloyds syndicate member Talbot, which it acquired last year. VR was initially capitalized by private equity groups Aquiline Capital, Vestar Capital Partners, New Mountain Capital, and private equity affiliates of Goldman Sachs and Merrill Lynch. The company went public in July 2007. VR is very well capitalized for the size of its current business, with cash and investments of 2.7x loss reserves, and debt-to-capital of only 13.7%. Its “A-” rating from A.M. Best is typical for the Bermuda “Class of 2005” and more indicative of its limited track record than its financial health and operations. Its combined ratio YTD is still 93% even after Ike and Gustav took it up to 122% in Q3. ABS and non-agency MBS of $653MM is 34% of book value but the average rating for the total portfolio is “AAA-” and the duration is a low 2.2, which is consistent with its short-tail focus and should provide some cushion against widening credit spreads. Growth was flat last year (pro forma for Talbot) but VR is very well positioned to grow next year.

**Table 3 – Leverage and Capital Adequacy**

* Medians exclude Berkshire Hathaway and AIG. See endnotes for an explanation of terms and calculations.

XL Capital, based in Bermuda and founded in 1986, is a diversified P&C insurance, life insurance and reinsurance company with 77 offices in 27 countries. Its reinsurance businesses are ranked among the 12th largest globally. XL’s situation shows how confidence is much easier lost than regained, and is a good example of how, in today’s environment, investors sell first and ask questions later. XL’s price/book multiple is lower than AIG’s, and from its stock price trajectory, one would think that XL was headed for the same explosive fate, but without a bailout. However, XL’s current operating performance, and even the rating agencies that give XL a “negative” outlook, paint a much more positive picture. The rating agencies say XL has “strong” capital adequacy. XL’s debt-to-capital ratios in Table 3 do not reflect that $745MM of debt converts to equity on 2/11/09. On a pro forma basis, debt/capital and debt+pfd/capital are a very reasonable at 17% and 27% respectively. Its fixed income portfolio has an average rating of “AA,” on par with the group, and an average duration of 4.1 years, the same as PRE and lower than Everest Re and Odyssey Re. XL’s ABS and non-agency MBS is slightly higher than the group as a percentage of book equity, at 77%, but lower than RenaissanceRe (RNR) and Endurance (ENH) as a percentage of total cash and investments. Its CMBS portfolio is now at $2.4 billion, after $800MM was sold in Q3, bringing it close to ACE’s $2.3 billion level. Its 10% decline in premiums written this year is about the same as for Everest and RenaissanceRe, and less than Berkshire’s 25% decline or ACE’s 22% drop in reinsurance premiums. Besides, sacrificing growth for pricing discipline is a virtue. Its combined ratio of 97.7% YTD is better than Everest (RE), Odyssey (ORH), Endurance and AIG, and about the same as AXS. None of this explains the 85%+ drop in XL’s share price this year. There must be more to the story….

A Closer Look at XL

1. Guilt by Association with Credit Default Swaps

Most of XL’s problems stem from the financial guaranty company, Syncora (SCA). Formerly known as Security Capital Assurance, Syncora was a subsidiary of XL Capital until XL brought its ownership below 50% through secondary market sales following Syncora’s 2006 IPO. Last year and earlier this year, XL Capital had a real mess on its hands because Syncora was facing serious issues with credit default swaps – very much like AIG – and XL Capital was on the hook for some of the risk.

In addition to the Syncora issues, XL had it’s own challenges, including the integration of several acquired businesses, strengthening its enterprise risk management systems, and de-risking an investment portfolio that had become too heavily laden with mortgage-backed securities.

In March of this year, XL announced that it was bringing in a new CEO, Mike McGavick, to turn things around. Mike had a great track record of success at CNA and at Safeco, which he substantially turned around in less than a year. A number of his moves at XL look like they come straight from his Safeco playbook: move quickly and get the financial pain out of the way; look to pay down debt through asset sales; invest in systems in order to wring efficiencies out of poorly-integrated acquired businesses, and ruthlessly drive down costs wherever possible.

**CDS = “Collateralized Death Spiral”**

Mike’s most immediate challenge was Syncora. As the credit quality of the debt underlying Syncora’s credit default swaps eroded, it faced the same death spiral – ratings cuts, collateral calls, security sales, capital drain, ratings cuts, collateral calls… – that hobbled AIG. XL was only a minority owner of Syncora, but as of 6/30/08 still had exposure through guarantees and reinsurance to a whopping $65.7 billion net par value of pre-IPO contracts.

Even though XL’s actual exposure under these contracts was estimated to be only $1.0-$1.5 billion, write-downs related to Syncora were damaging its financial statements – and its reputation. In July, Chubb was reported to have taken XL off of its approved list of markets for facultative reinsurance. S&P, Moody’s and Fitch all gave XL a negative outlook, citing its Syncora exposure.

XL needed to get out from under the Syncora cloud fast (and Syncora needed cash), so on August 5th, XL paid $1.8 billion plus 8 million common shares to erase over 98% of this risk through a settlement agreement with Syncora and certain of its counterparties (XL also transferred its remaining Syncora shares to a trust for Syncora CDS counterparties). This payment was funded with part of the $2.9 billion in new preferred stock and equity units issued this year, so the company’s cash balance was still improved versus the beginning of the year.

XL has put its Syncora exposure behind it, but it has been much harder for the company to undo the damage to its reputation. It didn’t help XL that at the same time that it announced the earnings hit for the Syncora settlement, it reported over $1 billion in mark-to-market losses on its fixed income portfolio. Most of the losses were non-cash – approximately $825MM was unrealized losses due primarily to increasing credit spreads. However, the combination of these charges was enough to trigger rumors that the company was on the brink of insolvency. These rumors prompted management to host its earnings call before its third quarter numbers were finalized, and to release detailed data on its portfolio. So far, investors seem unconvinced. What XL needs is more third party validation.

A.M. Best upgraded its outlook from negative to stable following the Syncora settlement, and said that with McGavick at the helm, Syncora behind it, and its latest round of new capital, the company now has the resources befitting a strong insurance franchise. However, S&P, Fitch and Moody’s still have a negative outlook. Chubb has not, as far as I can tell, put XL back on its preferred insurer list.

S&P and the rest actually say some very positive things about XL, but until they change their official outlook, it is likely that investors will focus more on the negative headline than the positive story. In maintaining its negative outlook, S&P cites “a track record of inconsistent earnings performance; material, though reduced, exposure to large catastrophic losses; susceptibility to further declines in the investment portfolio; and business-integration challenges borne from the relatively rapid building of a very strong and diversified global competitive position.” However, S&P also makes a number of positive comments:

Pro forma Sept. 30, 2008, capital adequacy is strong and incorporates both the market valuation of XL’s investment portfolio and expected Hurricane Ike and Gustav losses that, though material, were within our expectations. …

We expect XL to produce a strong, steady earnings stream from its ongoing core operations at a level equal to that of similarly rated peers, despite soft market pressures. An accident-year and calendar-year combined ratio of less than 100% and a pretax return on revenue (excluding realized gains or losses) of 15% will result from continued pricing discipline and operating performance, absent an unusually severe catastrophe year. Furthermore, financial leverage (debt plus preferreds including hybrids) will be no more than 40% of total capital when reflecting the February 2009 conversion of $745 million of senior notes into equity, and fixed-charge coverage (excluding noncash and unusual charges) will approach 5.5x in 2008 and 2009.

It seems clear that S&P’s reluctance to lift its “negative” outlook is based more on XL’s history than its present status, and that barring any significant missteps, the outlook will be upgraded. However, it could take some time. S&P implies that it will need to monitor results for the next “couple of years” before changing its outlook.

2. Investment Portfolio and Business Risks – Real but Declining and Manageable

Since the Syncora settlement did little to help XL’s stock price, I dug deeper into the two other logical issues: the investment portfolio and the risk portfolio. S&P and A.M. Best both mention XL’s investment performance, and it is clear from my conversations with people in the industry that there are still concerns about what may be lurking in XL’s portfolio.

I looked at XL’s Q3 credit supplement, which provides a substantial amount of detail on the portfolio, including marks versus par and amortized cost. I put together a summary of the data, which shows that fair values seem reasonable, especially when considering the true likelihood of nonpayment rather than temporary swings in treasury rates and credit spreads. XL has $1.3 billion of subprime, Alt-A and second lien loans; however, even the AAA-rated portion of this ($800MM) is carried at 75% of par. The A-rated portion ($300MM) is carried at only 41% of par. The combination of actual credit impairments and today’s insane credit spreads justifies these marks, but it is hard to imagine that 25% and 59%, respectively, of these loans actually will not be repaid. Its $758MM of non-ABS CDOs are carried at 64% of par. Its CMBS are marked at 88% of par, even though default rates for commercial mortgage-backed securities historically have averaged less than 1%. The only mark I question is carrying its $1.4 billion of consumer ABS at 99% of par. XL management has acknowledged the concerns about its portfolio and has already reduced its levels of riskier debt securities and equities. Overall, the portfolio has its issues, but nothing that would justify XL’s current stock price.

One last thing I considered was XL’s exposure to D&O claims. About 24% of XL’s business is professional liability, and a recent study by Advisen Ltd. ranks XL as the third largest writer of D&O coverage for financial institutions, with an 11% market share. The rest of the top five are AIG (19%), Lloyds (17%), Chub (10%) and Travelers (6%). The study predicts that settlements and defense costs for subprime-related D&O claims will be $27 billion, of which the insured portion will be $5.9 billion. This would put XL’s share at $650 million, or 6.5% of book value. This is material, but, again, not enough to explain the current stock price.

The Power of Rumor Over Reality

I spoke to some of my contacts in the industry to try and get to the bottom of this. They talked about XL having a lot of “those toxic subprime” securities in the portfolio, and XL’s having been involved in the whole credit default swap nightmare – nothing new. The good news was that I also heard that XL was “an important market” for them, and that they had not heard anything negative about XL lately. When I probed for details about XL, it became clear that nobody I spoke to had done any primary research. Their views were driven by industry chatter, which in this case seems to lag, not predict, reality.

The time to make a negative call on XL was in late 2007 and the first half of 2008. By the time the negative buzz reached its peak in October ’08, the vast majority of XL’s problems were already behind it.

XL has raised new capital; virtually eliminated its Syncora problem; made progress in de-risking its investment portfolio (including the $800MM reduction in CMBS mentioned earlier, plus a $500MM reduction in corporate credits and other actions); and hired a new “Chief Enterprise Risk Officer” from Goldman Sachs. While XL is likely to have another significant round of mark-to-market losses in the fourth quarter, this will impact “comprehensive income” not net income.

The market has priced disaster into XL’s shares, but while I see challenges, I do not see any signs of impending doom. Mike McGavick has the skills and experience to lead a successful turnaround and has already made real progress. Meanwhile, premium rates for property, catastrophe and professional lines are already firming and the outlook is very good for XL in 2009. The conversion of its senior notes to equity in February of 2009 may be a catalyst for significant appreciation of the stock, especially if XL fares well during January renewals. Unfortunately for XL, unless credit spreads tighten dramatically by year-end (the Fed is certainly pushing in the right direction), it is likely that Q4 mark-to-market losses will offset, or at least temper, positive Q1 news. One thing that would help would be if following Q4 results, one of the other rating agencies revises its outlook to “stable.”

Notes:

“Total Capital” refers to book equity plus minority interests, liquidation preference of preferred stock, and debt. “Capital” refers to “Total Capital” excluding accumulated other comprehensive income (“AOCI“). “Book” and “Book Value” refer to book common equity excluding AOCI. Prices are closing prices on 11/24/08. “Unlevered Value” is equity market value plus minority interest, preferred stock and debt, less an estimate of excess cash for RNR and VR. Premiums earned are for LTM ended 9/30/08. Company ratings are S&P financial strength ratings, or, if there is no FSR, ratings for the P&C operating companies. Validus rating is from A.M. Best. Portfolio average ratings are S&P except Everest, which is Moody’s. Figures for ORH are pro forma for an additional $150MM of share repurchases at an assumed $45/share average price. For AIG, figures: (1) are pro forma for the issuance of $40B Series D Pfd Stock and associated debt repayments, (2) do not include non-cash addition to APIC recorded with Series C Pfd Stock, (3) reflect preferred stock on an as-converted basis, and (4) include $156B of “other long-term borrowings” at face value, not $39.1B reported fair value.

Posted in Financial Services, Insurance, Mid-Large Cap, Special Situation. Tags: AIG, business, CDS, CMBS, Credit Default Swaps, Economy, Insurance, long ideas, MBS, Reinsurance, Subprime, Syncora, XL Capital. 2 Comments »

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