Sunday, December 9, 2007

Alleghany Corporation - analysis and valuation

Alleghany Corporation (Y)

Alleghany is an insurance holding company based in New York City. Alleghany has a rich and colourful history dating back to 1929. While the composition of Alleghany’s businesses have changed over the years, Alleghany’s modus operandi as an opportunistic yet conservative investment company remains the same. Over recent years the Company has developed a core focus in property and casualty insurance.

Alleghany’s largest shareholders are the Kirby Family and Alleghany continues to operate very much like a private company. Management don’t provide conference calls and rarely give media interviews. This makes scuttlebug on the company difficult and explains why Alleghany receives no analyst coverage. They have recently received some favourable press in Barrons.

Alleghany’s philosophy

This is stated on the front page from their website. It can be summed up into the following key aspects.

1. “Objective is to create stockholder value” over the long term ie. By growing book value per share at a double digit pace.

2. “ownership and management of a small group of operating businesses and investments, anchored by a core position in property and casualty insurance.”

3. “operating businesses function in an entrepreneurial climate as quasi-autonomous

4. “Conservatism dominates management philosophy.”

5. “relatively few interests in basic financial and industrial enterprises” ie. concentration of investment resources.

Current Management & Insider ownership

Alleghany’s current CEO is Weston Hicks. Weston has done a solid job in his brief time as CEO although it is hard to properly assess his performance in a period of just under 3 years. Prior to joining Alleghany Weston was CFO of Chubb and prior to this a top-ranked insurance industry analyst and former managing director at J P Morgan securities. John Burns is Chairman (Allan Kirby former Chairman retired in 2006)and was extremely successful as Alleghany’s former CEO. John Burn’s continued involvement on the strategic and investment front is positive.

The Kirby remain the largest shareholders. Management are rewarded appropriately with stock incentives to achieve long term growth in book value and returns on equity. So the interests of shareholders and management appear properly aligned although the closed nature of management is not ideal from a corporate governance perspective.

Alleghany’s subsidiaries

Insurance subsidiaries

The core focus of Alleghany is property and casualty insurance. Its subsidiaries include:-

RSUI Group led by CEO James Dixon is the largest and most important insurance subsidiary , it underwrites specialty insurance in the property, umbrella/excess, general liability, directors and officers liability, or “D&O,” and professional liability lines of business .

RSUI was severely tested during the severe Hurricane season of 2005 by storms Katrina and Wilma , suffering US $303 million in pre-tax catastrophe losses . RSUI has since taken actions to reduce its loss exposures on a risk by risk basis and reviewed its overall book of business.

RSUI is Alleghany’s largest subsidiary writing $560 million in net written premiums for the first nine months to September 30 2007. The underwriting profit reported is $164 million with a 69% combined ratio. For 2006, the numbers were $503 million premium, $149 million profit and 70% combined ratio.
With over $900 million in surplus, RSUI is achieving in excess of a 15% return on equity.

Darwin Professional Underwriters (55% majority ownership, listed ticker “DR”) – specialist insurer focused on professional liability insurance and related lines

Stephen Sills is the CEO and he had a great track record. He was founder and former CEO of Executive Risk which was eventually sold to Chubb Corp. He has brought a number of his colleagues into Darwin from Executive Risk. Darwin’s growth and performance to date has been excellent, Weston Hicks CEO commented in the Annual report 2006 “Darwin Professional Underwriters has grown from a start-up managing agency to a publicly-listed insurance underwriting company in less than four years, producing almost $250 million of gross written premium in 2006 …The company is emerging as an innovative force in the specialty insurance marketplace, and we believe it has excellent long-term prospects.”

Darwin Professional is facing considerable headwinds in the form of softer pricing in the professional liability area with declines of over 10% in most lines. However, Darwin has been able to successfully increase its written premium by 6% in the most recent third quarter of 2007.

Darwin and insurance industry continues to benefit from a more favourable claims environment which will continue to place downward pressure on their loss expenses. Darwin has been conservative with reserving, recording much higher IBNR than its actual loss claims experience , this is likely to result in continuing favourable loss reserve releases as recent quarters have demonstrated. Its most recent combined ratio for the quarter end 30 September 2007 was 85% versus 96% for the year earlier.

Alleghany spun-off Darwin Professional in 2005 but retains 55% ownership. In August it did register an 8K which gives Alleghany the opportunity to sell down this stake but as of 30th September 2007, no stock had been sold. At 7th December 2007, Alleghany’s stake was valued at $235 million versus $202 million at 30th September 2007. Darwin has from the very beginning been an excellent investment for Alleghany with great prospects.

Capitol Transamerica Corporation or “CATA” (consisting of Capitol Indemnity, Platte River and Capitol Specialty)

CATA is a specialty insurer based in Madison, Wisconsin and led by David Pauly CEO who has done an excellent job since his appointment in 2003 at growing CATA’s profitability. CATA wrote a combined ratio of under 90% in 2006 and CATA’s statutory surplus was around $250 million as at 30th December 2006. Around 72% of their gross written premium was property and casualty and the remainder commercial surety.

They wrote $189 million in gross written premium in 2006 recording an underwriting profit of $19.1 million versus $173 million and $15.6 million in 2005. The difference was primarily due to favourable reserve releases pre-tax of $13.6 million in 2006 and $5.1 million in 2005. It is worth noting that in 2004 CATA reported a $8.9 million underwriting loss due to reserve strengthening of $10.6 million related primaril to construction defect claims. CATA exited the construction lines of its commercial surety business in 2004.

CATA continues to benefit from favourable reserve releases in 2007. For the first nine months ended 30th September 2007 it has written $162 million in GWP with $19.5 million in underwriting profit recording a combined ratio of 86%. This is due largely to $14million pre tax reserve releases in 2007 compared to $11million for same period 2006.

Employers Direct Corporation - EDC & Homesite Group (minority ownership – 33%)

Employers Direct Corporation was acquired by Alleghany in July for $192 million and EDC writes workers compensation insurance on a direct basis in California. It appears to have grown rapidly since 2002 and continues to be managed by founder and CEO Jim Little.

Alleghany took a 33% ownership stake in Homesite, a monoline home insurance provider, for $120 million in December 2006. For further discussion of Homesite I can recommend readers review pages 8-9 of the Plymouth Rock Assurance Annual shareholders letter for 2005 (as an aside I recommend reading Chairman Jim Stone’s letters as they are full of insightful wisdom on the insurance business).
Alleghany’s acquisition of Homesite and EDC signals their intention to build a diversified group of insurance holdings including strategic stakes such as Homesite.

Alleghany Properties

During 1994, Alleghany sold Sacramento Savings Bank which it had acquired in 1989. As part of the deal Alleghany purchased the real estate and related real estate assets of Sacramento Bank. The total book value of these properties in the Sacramento region of California was $22.6 million at December 2006 and consisted of 345 acres of land classed for multi-family residential and commercial use. During 2006 Alleghany sold 59 acres having a book value of approximately $5million for a net gain on sale of $23 million.

It is fair to conclude Alleghany’s real estate is probably worth over $120 million or $13 in excess of its book value. However, given the housing downturn particularly in the Sacramento housing market, Alleghany may not seek to fully realize this value in the short term and will likely wait patiently for the housing market to improve.

Investment Portfolio

Alleghany’s investment approach can be summed up by the following quote from Weston Hicks & F M Kirby 2005 annual report… “While we continue to pursue suitable acquisitions, we are working to grow Alleghany’s capital by investing in public equity securities when we see the opportunity to earn at least a 10 percent after-tax return…. Our investment approach, however, is first and foremost downside risk in orientation; we seek a non-diversified equity portfolio in which the core investments have measurable and limited downside, with significant potential upside to be realized over a three- to- five year investment horizon.”

Alleghany’s $1.2 billion equity portfolio is a concentrated one, dominated by a $400 million stake in railways through Burlington Northern , a $205 million shareholding in insurance via Darwin Professional and another $300 million or so invested in an assortment of energy oil and gas producers. Weston described in his 2006 annual report that they were pleased by the hedged nature of their investment portfolio as energy and railway holdings are cyclical and work as a hedge against their bond portfolio which will tend to perform better during an economic downturn.

Based on Alleghany's annual report for 2006, Alleghany's $3 billion bond portfolio is conservative consisting mostly of highly rated or liquid debt securities. Over 73% of bonds hold a AAA rating with just 1% having no rating or below investment grade.

Valuation and Conclusion

Currently as of 7th December Alleghany trades for $420 a share. Alleghany’s stated book value is $294 per share. Alleghany’s real estate is probably worth another $12+ per share more than its book value. So at over $300 per share the price to book value is around 1.4x.

They should earn over $30 per share in 2007 which puts the PE at 14x earnings. Note the PE takes no account of their minority investment of $400 million in Burlington Northern or $120 million stake in Homesite. Therefore growth in book value is a better way to look at Alleghany, and insurers generally, given it includes increases in the market value of their equity securities.

Their book value has grown around 8.7% over 5 years ending 31st December 2006. However, in the last 5 years Alleghany’s business has transformed considerably, from having $1.3 billion in cash and invested assets and no insurance subsidiaries in 2001 to $4.1 billion and three insurance subsidiaries and another significant investment in another insurer as at December 2006. Cash and invested assets should reach $5billion or $546 per share by 31st December 2007 with no debt leverage and 25% invested in equity investments.

Alleghany’s insurance subsidiaries are capable of doing a 15% ROE. If they can do an underwriting profit of $15-20 per share and a 5% after tax return on $546, it would be reasonable to expect they can compound book value at a higher rate of 12-15% going forward. For 2006, Alleghany reported a 15% increase in book value and for the first nine months of 2007 a 12.2% increase in book value. It seems reasonable they can grow their book value at 12-15% for the next 2-4 years.

The main risks here are heightened hurricane activity over the next few years and softer insurance pricing. There is also the risk of lower interest income but this would be balanced by increase in the value of their bonds & equity securities.

If the current credit crunch continues through 2008 with a resulting economic slowdown, Alleghany is well positioned to opportunistically take advantage of distressed selling & its strong balance sheet with no debt leverage means it is well-insulated from the credit market problems.

In conclusion, fair value for Alleghany would be around 1.5x its book value of $300, or $450 per share. In terms of buying Alleghany shares I believe they represent good value below 1.2x book or below $365 per share.

Please note: The opinions expressed above reflect authors own opinions/point of view and are not intended as investment advice and should not be relied upon as such.

References: Alleghany annual and interim reports.

Disclosure: I have positions in Alleghany (Y) and Darwin Professional(DR)

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