<THE BORING PORTFOLIO>
Berkshire Hathaway, Part 5
The GenRe Merger
by Dale Wettlaufer (TMF Ralegh)
ALEXANDRIA, VA (Dec. 14, 1998) -- Last week, we discussed Berkshire Hathaway's (NYSE: BRK.A, BRK.B) insurance operations, from GEICO Direct Auto Insurance, to direct specialty insurance, to super-catastrophe insurance. Before we conclude this section on insurance operations, we should talk about General Re (NYSE: GRN), a company with which Berkshire has signed a definitive agreement to merge. GenRe is North America's largest reinsurer and its the world's third-largest reinsurer, according to National Underwriter Property & Casualty, a trade journal. GenRe put together a presentation on some of the thinking behind the merger, which you can find at the company's excellent website at www.genre.com or by clicking this link.
The deal was agreed upon at a price valuing GenRe at 22.3 times its trailing EPS at the time. Even more interesting, however, is price paid (equity value) relative to GenRe's insurance float and invested capital. Relative to insurance float, the price paid for the company was 1.1 to 1.22 times GenRe's float, depending upon how you treat a recoverable that was on GenRe's balance sheet at the time. As a multiple to invested capital however, the price was even more interesting. The equity value to invested capital multiple Berkshire agreed to was 0.565, which is not big at all. Looking at it another way, on the basis of adjusted book value, which is shareholders' equity plus reinsurance balances, unearned premiums, deferred policy benefits, and claims and claim expenses, Berkshire paid 0.74 times adjusted book.
The bottom line on the deal was that GenRe was cheap, even after the 26% premium to which Berkshire agreed. Here's why. Historically, General Re has achieved a combined ratio of 100%. Here are the historical combined ratios for GenRe that the company presented earlier this year:
5 years: 101.0% 10 years: 101.4% 20 years: 102.8% 30 years: 102.2% 40 years: 101.3% 50 years: 100.4%
Historically, then, the capital that comes into the company through underwriting insurance has been virtually cost-free. Combine this cost free source of capital with managers who have the ability to allocate this capital to very good investment opportunities and you have a powerhouse combination. And when I say investment opportunities, we're not just talking about "buy and hold" sorts of stock purchases. I'm talking about outright purchases of entire companies, publicly- or privately-traded, as well as "non-conventional" investments (as Buffett puts it, in addition to taking minority stakes in publicly-traded companies.
In the merger press release the two companies, Warren Buffett, and Vice-Chairman Charlie Munger named four synergies that they believed to justify the price paid:
1. "First, this transaction removes constraints on earnings volatility that have caused General Re, in the past, to decline certain attractive business and, in other cases, to lay off substantial amounts of the business that it does write. Because of both its status as a public company and its desire to maintain its AAA credit rating, General Re has, understandably, been unable to operate in a manner that could produce large swings in reported earnings. As part of Berkshire, this constraint will disappear, which will enhance both General Re's long-term profitability and its ability to write more business. Furthermore, General Re will be free to reduce its reliance on the retrocessional market over time, and thereby have substantial additional funds available for investment."
2. "Second, General Re has substantial opportunities to develop its global reinsurance franchise. As part of Berkshire, General Re will be able to make investments to grow its international business as quickly as it sees fit."
3. "Additionally, General Re will gain tax flexibility as a result of the merger. In managing insurance investments, it is a distinct advantage to know that large amounts of taxable income will consistently recur. Most insurance companies are in no position to make this assumption. Any Berkshire insurance subsidiary can fashion its investment strategy without worry as to the presence of taxable income in the future due to Berkshire's large and diverse streams of taxable income."
4. "Finally, Berkshire's insurance subsidiaries never need to worry about having abundant capital. Therefore, they can follow whatever asset strategy makes the most sense, unconstrained by the effect on the capital of the Company of a sharp market decline. Periodically, this flexibility has proven of enormous advantage to Berkshire's insurance subsidiaries.
"These synergies will be coupled with General Re's pristine worldwide reputation, long-standing client relationships and powerful underwriting, risk management and distribution capabilities. This combination virtually assures both Berkshire and General Re shareholders that they will have a better future than if the two companies operated separately."
In other words, the company can be run more rationally, to satisfy owners with longer-term objectives instead of having to balance the needs of a more diverse shareholder group than General Re currently has. Also, due to its diversified nature, Berkshire has the cash flow necessary to bridge the gap between optimal investment decision-making at GenRe and the need for liquidity to satisfy claims. The timing differences between the point where economic income is generated and taxable income is generated are also bridged by Berkshire's cash flow. What all of this means is that the allocation of General Re's investment portfolio between equities (again, this includes buying entire companies) and fixed income securities can be increased when the investment decision makers at Berkshire feel the time is right.
Bottom line on the General Re transaction, I believe it's a home run for Berkshire. More than that, I believe it's a Mark McGuire home run. It's a not a high shot that could get blown down or blown foul. This was a line shot straight out of the park.
Since we've talked about what I believe is Berkshire's most important subsidiary in GEICO, let's move on to identifying some of the other companies that are part of the entire package.
If you like Tiffany's-grade jewelry but don't like Tiffany's grade pricing, this is the place to go. Borsheim's offers 100,000 items in inventory and the services of premier gemologists and designers. The other part of Berkshire's jewelry operations is Helzberg Diamonds. Helzberg has expanded at a fast pace over the last couple years. Here's part of the story on that, from Helzberg's website: "The 90s have seen the most aggressive expansion and exciting changes in our company's history. In addition to opening new Helzberg Diamonds stores at an unprecedented pace, a decision was made to venture out of malls to create a much bigger store, and a different name for these new freestanding superstores was selected: JEWELRY3, with three times the selection of any mall jewelry store. The first five years of JEWELRY3 revealed that the public accepted the freestanding store format. However, to build on our successes and to fully communicate the heritage of one company, it was decided to put the Helzberg Diamonds name on the freestanding stores, too."
1996 was something of a disappointment. Helzberg CEO Jeff Comment turned things around last year for a nice mention in the 1997 letter to shareholders. In 1997, Berkshire's share of net earnings for jewelry operations was $18.3 million, up from $16.1 million the year before. On Monday, we'll talk more about Berkshire's retailers and other operations and possibly follow up with an update on Helzberg if I can talk to someone at the company.
Alex will be dealing with Borders (NYSE: BGP) over the next couple of days. The goal there is to put a value on the company. I've done some work on it and I believe it to be undervalued, personally. While I don't like the business, I don't plan to sell something I see as undervalued, either. Looking at the action in the stock price over the last few weeks, I believe the company is probably guiding or going to guide earnings expectations lower.
While its website is probably cooking (the operaters were very busy when I put in an order and their computer crashed as I was on the phone with them due to a surge of data moving through the system at noon), this may take away sales from the stores. If that's what the company is dealing with right now, it will probably make its revenue numbers and miss its earnings estimates. But I'm hardly going to make a move on buying or selling a stock based on what I think it will do for one quarter.
Nevertheless, one quarter makes the year at Borders. Hopefully its strategic planning will deal with the changing dynamics of the bookselling environment. My amateur view of things is that the dynamics are indeed changing and that Borders has not taken that seriously enough. In any case, Alex will deal with these questions over the next few days.
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Stock Change Bid ANDW - 3/16 17.63 BGP -1 5/8 20.88 CSL - 7/16 46.13 CSCO -3 1/8 80.38 FCH - 1/2 22.00 PNR + 3/8 36.25 TBY - 1/4 6.56
Day Month Year History BORING -2.61% -0.82% -2.87% 22.22% S&P: -2.17% -1.93% 17.60% 83.58% NASDAQ: -3.07% 0.89% 25.25% 88.95% Rec'd # Security In At Now Change 6/26/96 225 Cisco Syst 23.96 80.38 235.52% 2/28/96 400 Borders Gr 11.26 20.88 85.45% 8/13/96 200 Carlisle C 26.32 46.13 75.21% 4/14/98 100 Pentair 43.74 36.25 -17.13% 1/21/98 200 Andrew Cor 26.09 17.63 -32.45% 5/20/98 400 TCBY Enter 10.05 6.56 -34.67% 11/6/97 200 FelCor Sui 37.59 22.00 -41.47% Rec'd # Security In At Value Change 6/26/96 225 Cisco Syst 5389.99 18084.38 $12694.39 8/13/96 200 Carlisle C 5264.99 9225.00 $3960.01 2/28/96 400 Borders Gr 4502.49 8350.00 $3847.51 4/14/98 100 Pentair 4374.25 3625.00 -$749.25 5/20/98 400 TCBY Enter 4018.00 2625.00 -$1393.00 1/21/98 200 Andrew Cor 5218.00 3525.00 -$1693.00 11/6/97 200 FelCor Sui 7518.00 4400.00 -$3118.00 CASH $11273.22 TOTAL $61107.59
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