Odyssey Re Holdings… Again

What a Difference a Year Makes…
Last year I highlighted Odyssey Re as the stock I liked best. A good management team, conservative investment portfolio, good insurance underwriting, great management, and of course a cheap price were the main factors in my analysis. Flash forward one year and the shares have risen about 10% (including dividends) in an 11 month stretch where virtually every single stock plummeted in value. It may be a surprise though to learn that I like Odyssey Re just as much now as I did then. The company is even cheaper now, and many of the business specific risks I highlighted have been reduced or eliminated. While there are many interesting relative values available, Odyssey is still unquestionably a good deal in my opinion.

A Recap and Update
For the 12 months ending Dec 31st 2008, roughly two thirds of Odyssey’s gross premiums came from Reinsurance, and the balance came from standard insurance. From a geographical perspective, the premium breakdown between geographies is: ~57% Americas, 26% EuroAsia, and 17% London. This is essentially the same as last year as the business mix has been reasonably consistent.

The balance sheet composition has changed a bit though (all data from the 10-k):
-- Total Equity of $2.82B (up slightly)
-- Total Assets of $9.72B
-- Total Unpaid losses and loss adjustment expenses of $5.25B (up ~$100m)
-- Total Investments and Cash of $7.89B (down slightly)
Investment account breakdown
-- $3.93B in fixed income securities (down $300m)
-- $1.70B in Stocks and Investments at Equity securities ($61.9M in Fairfax Asia) (up $550m)
-- $1.20B in Short term investments
-- $0.76B in Cash
-- $0.22 in ‘other’ (down $230m, mostly due to CDS sales)

While the overall portfolio size has been fairly stable, the composition has changed dramatically. A big increase in equities and a decrease in CDS and bond investments understate the real shift that has occurred. In addition to the reduction in CDS and bonds, Odyssey removed all their equity hedges in the 4th quarter of 2008 and swapped out a big chunk of their Treasury bond portfolio (yielding <3%)>5%) mostly insured by Berkshire Hathaway. Coming into 2007 and 2008 Odyssey’s portfolio was structured to protect against a one in 50 or 100 year storm. It did just that as their portfolio returned 10+% during last years’ absolute meltdown.

The recent portfolio actions taken by Odyssey’s investment team in the 4th quarter show that current pricing on many assets are now discounting a very dire economic scenario, so shifting more money into more ‘risk’ assets is appropriate at this time. I whole heartedly agree and I’m excited to see Odyssey put more money to work in quality stocks and higher yield bonds.

Valuation:
Using the same methodology as last time, I’ll summarize Odyssey’s value with the last financials
1) At the current quote of $40 and change, Odyssey Re trades at roughly a 15% discount to stated book.
2) The current investment portfolio of $7.89B comes to about $133/share… which if you assume a 6% return and 35% tax rate, would place normalized earnings at >$5.15/share. (This statement makes an inherent assumption that underwriting profits will just cover the debt costs which could be argued, but so could the 6% return figure)
3) Note that while YoY the investment portfolio has decreased slightly the share count shrunk dramatically (~15%) so the portfolio value/share increased 10%.
4) The debt to equity ratio is only 17% (up slightly), so the buybacks have not sacrificed the balance sheet in any meaningful way and Odyssey was also an active repurchase of preferred stock during Q4.
5) Average diluted EPS (GAAP) over the past 5 years has been >$5.00/share and while much of the recent homerun profit may be viewed as one time it has improved the equity base for future years of big(ger) profits.
6) Odyssey Re has a 26% stake in ‘Fairfax Asia’ on the balance sheet listed at $61.9M. Fairfax Asia is a private subsidiary that owns a 24% stake in ICICI Lombard, a large Indian insurance company. Last year, I placed a fair value on this ownership by Odyssey of over $200m but given the thrashing various global equities have taken I’d probably haircut that by 50% to be more conservative.

Again, the Risks…
Of utmost importance is the risk in this investment. Last time I highlighted a plethora of risks that face owners of Odyssey Re common stock. Below I’ll provide an update on the various items:
1) Soft insurance market: While the insurance market has show signs that prices are rationalizing in specialty lines as well as some reinsurance lines, overall the pricing is still less attractive than it was last year. Contract terms will likely start to harden before pricing materially improves, and overall this will lower Odyssey’s loss rates in lieu of pricing improvements. Net net it appears that the light may be at the end of the tunnel, but given the government actions around the world, and most notably actions taken with AIG, I think there is not much to be optimistic about here yet… time will tell. Insurance operating results will be weak in the near term.
2) Hurricanes / Earthquakes / Etc: Nothing has changed fundamentally about Odyssey’s core business. You don’t buy this one if you find that quarterly EPS volatility makes you queasy.
3) Lawsuits: As I followed up in July last year the baseless suits that were lurking around the Odyssey and Fairfax regarding tax avoidance were cleared up as the IRS closed the books on the years in question giving ORH a clean bill of health.
4) Lack of shareholder control: If anything, this ‘risk’ has worsened. As Odyssey Re has continued to buy back shares as an astronomical clip, the free float has decreased and Fairfax’s control has only increased (if that is possible). This continues to be a business you do not invest in unless you trust Fairfax completely. On a related note, a Canadian subsidiary (Northbridge) of Fairfax in a very similar situation to Odyssey Re was purchased for a premium of 35%+ of the stock price last year for a price to book of 1.3x. Fairfax (which stands for “Fair and Friendly Acquisitions”) has continued to treat its minority shareholders more than fairly in these dealing (as an example, Fairfax’s 1.3x book price for Northbridge was higher than not only the P&C Insurance sector on aggregate, but more than Fairfax’s own market value). I view the minority position of ORH as actually a potential catalyst if Fairfax chooses to take full control in a manner similar to Northbridge. A similar deal to the one for Northbridge would yield a 50% premium to the current price of $40/share.
5) CDS volatility: Since last year, the CDS position has been wound down quite substantially. While some investors may be turned off by the fact that ORH stock may no longer behave as a disaster insurance policy, there is no doubt that results will be perceived as much more transparent and less volatile by the market. This is probably marginally positive overall.

Summary:
So what you have here is still a solidly run insurance company, trading at a low (but admittedly not a crazy cheap) price of 80-85% of adjusted book and perhaps less than 8x earnings. They have repeated shown an adroit ability to side step big mistakes and do the basics well. Their book value compounding since early 2000’s has been near 20% annually while most supposed giants of the industry have nearly obliterated their franchise. Odyssey not only avoided, but profited from the follies of others in their sector. Now as losses and incompetence has been exposed, they are beginning to take risks on the investment side that favor those with cash ready for deployment. Additionally, they have the capacity waiting and ready for rational pricing in insurance policies. While I will concede that the current market environment certainly will present much ‘cheaper’ stocks for those willing to dig, I question how many will be as safe or as ‘easy’ as Odyssey.

Buying a solid insurance company with a world class investment arm for a 15% discount to book has tended over time to be a rewarding proposition and I believe that will be the result in this instance as well.

Ben Hacker

Disclosure: Ben Hacker and clients of Remick Capital, LLC owned shares of Odyssey Re and Fairfax Financial at the time of this writing.