American Express (AXP) has been a fixture of payment systems since the rough and tumble days of horse back riding. There has always been a need for secure payment systems; the question has been who is going to pay for it. Back in the day, if a person purchased an item, that person was often responsible for getting it shipped.
In today's world, the merchant pays the "freight." Because AXP delivers the funds on behalf of the purchaser, AXP receives a payment in the form of discount revenue.
There are two lines of business which deliver discount revenue. The first is charge cards. Charge cards do not have a lending balance, but do have a receivable. Once a purchaser charges an item, AXP pays the bill and then waits to collect from the purchaser at the end of the month. AXP has a "reverse float," that is money not held, but owned. This "reverse float" has costs to it, but these costs are borne by the annual card fees.
The second line of business to deliver discount revenue is the credit card business. Credit cards do have a lending balance which charges high interest rates. These lending balances are funded by low-cost borrowing through the capital markets. With the capital markets frozen, AXP has been scrambling for ways to replace the low-cost borrowing at exactly the time default rates on loans are rising. Not a good combination.
To ascertain the value of AXP, one needs to weigh these two lines of business. Each does have a value. The charge card business is more consistently profitable, but has slower growth. The credit card business has greater growth, but is more cyclically profitable. Historically a credit business trades at a low of .5X book value up to a high of 1.5X book value with an "intrinsic value" of 1X book value. The book is what is required to manage the net spread business. AXP has $75 billion of receivables, with a new bank requirement of at least 6%: meaning roughly $5 billion of net worth.
The charge card business should generate about $4 billion of pretax profits with a multiple of roughly 6X giving $24 billion of value. The combination of the two businesses should be roughly $30 billion. In addition, there is a processing business globally which should make $1 billion pretax profits with a multiple of 10X, given the valuations of MasterCard and Visa. The total of $40 billion puts an "intrinsic value" of $35 - a far cry from today's stock price.
Thursday, November 6, 2008
What's It Worth? (ALL)
Famous investor Warren Buffett said in his 1996 Annual Report, "An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds." In a prior post (10/27/2008), I posted a chart showing that Allstate (ALL) had consistently generated underwriting profits, meaning that the cost of the float (money held not owned) has been less than zero.
So what is ALL worth? ALL's float is $18.5 billion. This float is lower than the premiums (about $27 billion) - demonstrating that ALL has a "short-tail" product. The growth of the float is about the growth rate of the economy - 2.5%. So, in 10 years, the value of the float may be about $24 billion. (During the past six years, float has grown even more slowly because of increased use of reinsurance - of course that helps the "cost of float.")
The cost of this float is variable. ALL has experienced a range from 89% to 103%, including catastrophe costs. For the cost of float, I assume -3%. I arrive at this because Progressive uses a target of -4%, setting a competitive challenge for others.
This negative cost of float is added to the investment return. The return on investment (excluding capital gains and losses) has averaged 5% over the past ten years. After adjusting the total for a 30% tax, the combined cost of float and investment yield is 5.6%, providing about $1.4 billion.
Valuing this $1.4 billion income properly is essential. It is likely to grow slowly, at 2.5%, but, without high risk - while insurance contracts are fairly commoditized, they are sticky. By adding a risk rate of 1.5% added to a 5% government rate, I arrive at a discount rate of 6.5%. (Inflation is not a focus because roughly offsetting effects run through the entire calculation.)
With a discount rate of 6.5%, but a growth rate of 2.5%, I have a denominator for the $1.4 billion, estimating the value of the float 10 years hence at $35 billion or $17 billion today. (It is merely coincidental how close this estimate is to the present float value.) By adding this to the current net worth of ALL, I should have an estimate for the likely worth.
The most significant recent issue facing ALL (and other insurers recently) has been the change in value of ALL's investments. Whereas the 2008 investment write-offs related to AIG, Fannie, Freddie and Lehman were small - 2% - as a function of the balance sheet, but they were large 10% - as a function of net worth. In addition, there are significant unrealized losses in the valuation of mortgage-related securities. For the purposes of this calculation, I am assuming the conservative GAAP measure (which is not used for statutory insurance underwriting purposes) of $17 billion.
Combining the two numbers provides a value of $34 billion. ALL has 536 million shares outstanding with the per share value figuring around $63 per share. This computation includes no value for the life insurance component. I have chosen to exclude life insurance value because of the increased complexity and excessively competitive pricing (another post, another day).
So what is ALL worth? ALL's float is $18.5 billion. This float is lower than the premiums (about $27 billion) - demonstrating that ALL has a "short-tail" product. The growth of the float is about the growth rate of the economy - 2.5%. So, in 10 years, the value of the float may be about $24 billion. (During the past six years, float has grown even more slowly because of increased use of reinsurance - of course that helps the "cost of float.")
The cost of this float is variable. ALL has experienced a range from 89% to 103%, including catastrophe costs. For the cost of float, I assume -3%. I arrive at this because Progressive uses a target of -4%, setting a competitive challenge for others.
This negative cost of float is added to the investment return. The return on investment (excluding capital gains and losses) has averaged 5% over the past ten years. After adjusting the total for a 30% tax, the combined cost of float and investment yield is 5.6%, providing about $1.4 billion.
Valuing this $1.4 billion income properly is essential. It is likely to grow slowly, at 2.5%, but, without high risk - while insurance contracts are fairly commoditized, they are sticky. By adding a risk rate of 1.5% added to a 5% government rate, I arrive at a discount rate of 6.5%. (Inflation is not a focus because roughly offsetting effects run through the entire calculation.)
With a discount rate of 6.5%, but a growth rate of 2.5%, I have a denominator for the $1.4 billion, estimating the value of the float 10 years hence at $35 billion or $17 billion today. (It is merely coincidental how close this estimate is to the present float value.) By adding this to the current net worth of ALL, I should have an estimate for the likely worth.
The most significant recent issue facing ALL (and other insurers recently) has been the change in value of ALL's investments. Whereas the 2008 investment write-offs related to AIG, Fannie, Freddie and Lehman were small - 2% - as a function of the balance sheet, but they were large 10% - as a function of net worth. In addition, there are significant unrealized losses in the valuation of mortgage-related securities. For the purposes of this calculation, I am assuming the conservative GAAP measure (which is not used for statutory insurance underwriting purposes) of $17 billion.
Combining the two numbers provides a value of $34 billion. ALL has 536 million shares outstanding with the per share value figuring around $63 per share. This computation includes no value for the life insurance component. I have chosen to exclude life insurance value because of the increased complexity and excessively competitive pricing (another post, another day).
Wednesday, November 5, 2008
Legendary CEO not Investment
Al Ueltschi (prounounced Yule-chee) has one of the most remarkable careers in business. He moved from legendary pilot to the creator of FlightSafety, the leader in pilot training, to funding ORBIS, an internationally-focused ophthamological charity organization. At 91, he continues to excel and participate.
Berkshire Hathaway (BRK) purchased the FlightSafety in 1996 for $1.5 billion. In the 2007 BRK annual report, Chairman Buffett commented that FlightSafety had pre-tax operating earnings of $111 million, and a net investment in fixed assets of $570 million. Al Ueltschi drove a hard bargain; Buffett paid nearly 15 times EBIT. EBITDA is not given, but FlightSafety probably had depreciation of 15% of fixed assets, putting the "D" of EBITDA at $80 million. If so, then Chairman Buffett probably paid 8 times EBITDA.
The hazards of paying a reasonble amount for EBITDA (7-10X), but a high amount for EBIT (over 12X) shows up here. Because FlightSafety is a "capital pig" (revealed by the high depreciation number), the results have been unlegendary.
Pre-tax operating earnings in 2007 were $270 million, a earnings increase of $159 million since 1996. Applying the same valuation that BRK paid for the company, FlightSafety would be worth $3.6 billion - better than a double. However, BRK has invested an additional $1.635 billion in capital expenditures. The not-tax-adjusted rate of return for this "it-put-up-more-to-earn-more" investment is in the low single digits.
But it may be worth such a low return to BRK to have the influence of such an amazing CEO. Here are a few words from Al Ueltschi: "We're all just human beings and we all do the best we can. We can make a difference by helping people. We have the greatest opportunities in the world."
Berkshire Hathaway (BRK) purchased the FlightSafety in 1996 for $1.5 billion. In the 2007 BRK annual report, Chairman Buffett commented that FlightSafety had pre-tax operating earnings of $111 million, and a net investment in fixed assets of $570 million. Al Ueltschi drove a hard bargain; Buffett paid nearly 15 times EBIT. EBITDA is not given, but FlightSafety probably had depreciation of 15% of fixed assets, putting the "D" of EBITDA at $80 million. If so, then Chairman Buffett probably paid 8 times EBITDA.
The hazards of paying a reasonble amount for EBITDA (7-10X), but a high amount for EBIT (over 12X) shows up here. Because FlightSafety is a "capital pig" (revealed by the high depreciation number), the results have been unlegendary.
Pre-tax operating earnings in 2007 were $270 million, a earnings increase of $159 million since 1996. Applying the same valuation that BRK paid for the company, FlightSafety would be worth $3.6 billion - better than a double. However, BRK has invested an additional $1.635 billion in capital expenditures. The not-tax-adjusted rate of return for this "it-put-up-more-to-earn-more" investment is in the low single digits.
But it may be worth such a low return to BRK to have the influence of such an amazing CEO. Here are a few words from Al Ueltschi: "We're all just human beings and we all do the best we can. We can make a difference by helping people. We have the greatest opportunities in the world."
Tuesday, November 4, 2008
Headed For Exit
Despite Warren Buffett's continued purchase of Wells Fargo (WFC) shares, he apparently does not have such enthusiasm for banks in general. Recently, Kansas Bankers Surety, a subsidiary of Berkshire Hathaway (BRK), was directed by Chairman Buffett to stop insuring bank deposits over the FDIC limit of $100,000.
In 1996, he boasted of the acquisition, writing "Kansas Bankers Surety (KBS), an insurance company whose name describes its specialty. The company, which does business in 22 states, has an extraordinary underwriting record, achieved through the efforts of Don Towle, an extraordinary manager. Don has developed first-hand relationships with hundreds of bankers and knows every detail of his operation." The deal was valued at about $75 million when it was announced.
Currently KBS does business in 38 states. The business earned $10.9 million last year on policy sales of $19.5 million, according to Oldwick, New Jersey-based ratings firm A.M. Best Co. While this is not high income given the price paid 12 years ago, KBS has excellent margins and is likely to require very little capital. Even more, KBS definitely requires very little staff with only 18 employees.
KBS is very profitable, but this exit will cost about 50% of the business. KBS still will defend lawsuits against bank executives (for those large bonuses?) and against costs of bad check writing. Compare KBS's profitability to that of Oklahoma City-based BancInsure Inc., a competitor of Kansas Bankers. BancInsure posted full-year 2007 net income of $2.57 million and policy sales of $47.4 million, according to data compiled by A.M. Best.
KBS clearly knows what they're doing. If KBS won't write the insurance, why would any individuals risk leaving any uninsured money in a bank.
In 1996, he boasted of the acquisition, writing "Kansas Bankers Surety (KBS), an insurance company whose name describes its specialty. The company, which does business in 22 states, has an extraordinary underwriting record, achieved through the efforts of Don Towle, an extraordinary manager. Don has developed first-hand relationships with hundreds of bankers and knows every detail of his operation." The deal was valued at about $75 million when it was announced.
Currently KBS does business in 38 states. The business earned $10.9 million last year on policy sales of $19.5 million, according to Oldwick, New Jersey-based ratings firm A.M. Best Co. While this is not high income given the price paid 12 years ago, KBS has excellent margins and is likely to require very little capital. Even more, KBS definitely requires very little staff with only 18 employees.
KBS is very profitable, but this exit will cost about 50% of the business. KBS still will defend lawsuits against bank executives (for those large bonuses?) and against costs of bad check writing. Compare KBS's profitability to that of Oklahoma City-based BancInsure Inc., a competitor of Kansas Bankers. BancInsure posted full-year 2007 net income of $2.57 million and policy sales of $47.4 million, according to data compiled by A.M. Best.
KBS clearly knows what they're doing. If KBS won't write the insurance, why would any individuals risk leaving any uninsured money in a bank.
Sunday, November 2, 2008
Outer Limits
Reading a recent WSJ article on the FDIC's "Limits of Leniency," I was shocked to see the ratios between income and size of home mortgages. When I was doing financial planning, I recommended a maximum limit of 2.5 times income for the principal size of the mortgage.
The reasoning was if the loan was $250,000, then it would take 30 years to pay down $8500 per year with zero percent interest. Add interest, taxes and insurance of roughly $16,500 per year and the total is $25,000. If pretax income is $100,000, then after tax is $60,000 and 40% of $60,000 is $24,000. Different taxes and interest could vary the limit down to 2 times or up to 3 times.
The recent article describes a 30 year old bartender "who watched the balance on his adjustable mortgage balloon from $424,000 to $463,000 in three years, while the value of his house dropped from $530,000 to less than half that." The article says that he is married. I would guess the combined income is roughly $50,000 giving a multiple of 9 times.
The article further describes another woman who refinanced her house for $637,288 in 2006. She and her husband, who works in a machine shop, take home a combined $70,000 a year. Each month, she makes the minimum payment on her loan, $2,416. At the same time, she watches the outstanding principal swell since that payment doesn't fully cover the interest costs. Now she owes $707,000 for a multiple of 10 times.
The only bright spot is that the house values have dropped to such an extent that a mortgage would work on the new reduced values. If the mortgages are modified by such a principal reduction and if the individuals maintain their incomes, the succeeding structure would seem to have longevity and not simply be a crapshot on rising home values.
The reasoning was if the loan was $250,000, then it would take 30 years to pay down $8500 per year with zero percent interest. Add interest, taxes and insurance of roughly $16,500 per year and the total is $25,000. If pretax income is $100,000, then after tax is $60,000 and 40% of $60,000 is $24,000. Different taxes and interest could vary the limit down to 2 times or up to 3 times.
The recent article describes a 30 year old bartender "who watched the balance on his adjustable mortgage balloon from $424,000 to $463,000 in three years, while the value of his house dropped from $530,000 to less than half that." The article says that he is married. I would guess the combined income is roughly $50,000 giving a multiple of 9 times.
The article further describes another woman who refinanced her house for $637,288 in 2006. She and her husband, who works in a machine shop, take home a combined $70,000 a year. Each month, she makes the minimum payment on her loan, $2,416. At the same time, she watches the outstanding principal swell since that payment doesn't fully cover the interest costs. Now she owes $707,000 for a multiple of 10 times.
The only bright spot is that the house values have dropped to such an extent that a mortgage would work on the new reduced values. If the mortgages are modified by such a principal reduction and if the individuals maintain their incomes, the succeeding structure would seem to have longevity and not simply be a crapshot on rising home values.
Dubai or not Dubai
My children and I have sat around in stunned amazement by the pictures of Dubai's real estate market. The number of skyscrapers, the luxury of the hotels, the indoor ski lifts and the islands created in the sea all combine to make Disney's imagination look impoverished. It is like Vegas on steroids.
When looking at these pictures, I had the same question when listening to Florida real estate stories three years ago - How is this possible? In the case of Dubai, I assumed it was simply oil rich folks with no respect for money. But an article in last Monday's WSJ shows it was also borrowed money. Here is a graph of the regional stock market's performance:
Here I'll disclose my U.S.-centric mentality. First, I didn't know they had stock markets in each of these regions - I just figured they owned big pieces of everyone else's. Second, I had no idea where Bahrain (island east of Saudi Arabia), Qatar (thumb sticking out into Gulf) and Oman (southeastern corner of Arabian peninsula) were.
Despite massive oil revenues, the governments are dependent on high prices. The WSJ reports, "Gulf states, on average, need prices above $47 a barrel to keep from running budget deficits. But some states are more vulnerable than others: Bahrain's so-called break-even price is $75 a barrel, compared with Saudi Arabia's $49 and Kuwait's $33, according to the International Monetary Fund."
These governments are now propping up the banks which are highly connected to what seems a Florida-like property flip. Compounding the problem is that the government itself owns nearly 50% of the developers, making it hard to say no. In a sign of the times it is reported that Dubai property prices rose 16% in the second quarter. That was much slower than the 42% price reported in the first quarter.
Look out below.
When looking at these pictures, I had the same question when listening to Florida real estate stories three years ago - How is this possible? In the case of Dubai, I assumed it was simply oil rich folks with no respect for money. But an article in last Monday's WSJ shows it was also borrowed money. Here is a graph of the regional stock market's performance:
Here I'll disclose my U.S.-centric mentality. First, I didn't know they had stock markets in each of these regions - I just figured they owned big pieces of everyone else's. Second, I had no idea where Bahrain (island east of Saudi Arabia), Qatar (thumb sticking out into Gulf) and Oman (southeastern corner of Arabian peninsula) were.
Despite massive oil revenues, the governments are dependent on high prices. The WSJ reports, "Gulf states, on average, need prices above $47 a barrel to keep from running budget deficits. But some states are more vulnerable than others: Bahrain's so-called break-even price is $75 a barrel, compared with Saudi Arabia's $49 and Kuwait's $33, according to the International Monetary Fund."
These governments are now propping up the banks which are highly connected to what seems a Florida-like property flip. Compounding the problem is that the government itself owns nearly 50% of the developers, making it hard to say no. In a sign of the times it is reported that Dubai property prices rose 16% in the second quarter. That was much slower than the 42% price reported in the first quarter.
Look out below.
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