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Shares of Markel (MKL) fell over 10% in Wednesday's trading session, followed by another 0.5% loss on Thursday. The financial holding company announced its intention to acquire Alterra Capital Holdings (ALTE). Shares of Alterra rose 21.7% on Wednesday in a response to the offer, but slipped 0.5% in Thursday's trading session.

The Deal

Markel announced that the respective boards of both companies have unanimously approved a definitive merger agreement in which Markel will be the acquiring party.

The deal values Alterra Capital at $3.13 billion, based on Tuesday's closing share prices. Based on Markel's closing price of $486.05 on Tuesday, the deal represents a 34% premium for Alterra's shares.

Shareholders in Alterra will receive 0.04315 shares in Markel and a cash payment of $10 for each of their shares they own. Combined, Alterra's shareholders will own approximately 31% of the shares in Markel.

With the tie-up, both firms aim to create a strong company which focuses on specialty insurance and investments. The companies have a strong record of underwriting discipline in niche market segments.

Vice Chairman Steven A. Markel commented on the deal, "We are very pleased to have reached this agreement to acquire Alterra, an impressive company with proven worldwide underwriting operations in product lines that we believe are highly complementary to Markel's existing lines. In particular, the addition of Alterra's reinsurance and large account insurance portfolios will serve to diversify and strengthen Markel's current book of specialty insurance business."

For the full year of 2012, Alterra is on track to generate annual revenues of $1.6-1.7 billion. The company could earn around $250 million for the year. The $3.13 billion deal values the firm at 1.9 times annual revenues and 12-13 times annual earnings.

Combined, both firms are expected to write annual gross premiums of $4.4 billion. The firms have a $6 billion equity position to support its growth ambitions. The firm's operations are 67% focused on insurance with the remainder on reinsurance.

Completion of the deal is subject to the usual closing conditions including regulatory and shareholder approval. The deal is expected to close in the first half of 2013.

Valuation

Markel ended its third quarter with $834.8 million in cash and equivalents. The company operates with $1.51 billion in short and long term debt, for a net debt position of almost $700 million. The $3.13 billion deal will be financed with roughly $1 billion in cash, and the remainder in stock.

For the first nine months of the year, Markel generated total operating revenues of $2.2 billion. The company reported net income attributable to shareholders of $196.6 million, or $19.67 per diluted share. The company could generate annual revenues around $2.9 billion, on which it could earn roughly $250 million, or around $25 per share.

Factoring in a 10% decline in Wednesday's trading session, the market values Markel at $4.2 billion. This values the firm at roughly 1.4 times annual revenues and 16-17 times annual earnings.

Markel does not pay a dividend at the moment.

Some Historical Perspective

Year to date, shares of Markel have risen some 5%. Shares gave up most of their gains for the year in a reaction to the deal. Shares of Markel started the year little over $400 per share to rise to $500 in November. Shares lost $50 per share on Wednesday, currently exchanging hands at $434 per share.

Shares of Markel traded at all time highs of $525 in 2007 to fall to lows of $225 in 2009. Shares more than doubled from that point in time. Markel has significantly grown its operations by making acquisitions and generating organic growth. Between 2008 and 2012, Markel expanded its annual revenues almost 50% from $2.0 billion to an estimated $2.9 billion in 2012.

Investment Thesis

Shareholders in Markel are not too happy with the announced deal. The 10% decline on Wednesday implies that roughly $480 million in market capitalization has gone up in smoke. Alterra's market capitalization increased by almost exactly the same amount, implying that the deal is seen as a simple wealth transfer from Markel's shareholders to those of Alterra.

Based on Wednesday's closing prices, the offer values Alterra at $28.72 per share. Based on Alterra's closing price of $28.04 per share, shareholders stand to receive another 2.4% return at current prices.

The deal multiples seem fairly in line with Markel's own valuation. While Markel offered an initial 34% premium, the implied premium has fallen to 24% as a result of the decline in Markel's share price. The deal values Alterra at 1.9 times annual revenues which compares to 1.4 times Markel's annual revenues. The deal values Alterra at 12-13 times annual earnings compared to a multiple of 16-17 times for Markel.

As a result of the expected share issuance, the market capitalization of Markel will increase to roughly $6.0 billion. Markel's gross net debt position will increase by roughly $1 billion as a result of the deal, coming in at $1.7 billion. Excluding the net cash position of roughly $500 million held by Alterra, the net debt position remains manageable at $1.2 billion.

The new combination will generate $4.5 billion in annual revenues and earn roughly $500 million on a pro-forma basis. Based on the implied market value of $6 billion, this values the "new" Markel at 1.3 times annual revenues and roughly 12 times annual earnings. This excludes the beneficial effects of synergies.

Shareholders in Markel are overreacting. The stock trades as if the company has made a huge transfer of wealth to shareholders of Alterra. I think their concerns are overdone, given the fair deal multiples. Furthermore, the new combination could report significant synergies, benefiting Markel's shareholders. The deal will not result in an excessive debt position either.

Shares have overreacted in response to the announcement of the deal. Opportunistic shareholders could benefit from a pull back.

Source: Shareholders Are Not Happy With Markel's Wealth Transfer To Alterra