Wesco Trades at a Discount, But Is It Better than Berkshire?

Wesco Financial Corporation (WSC) reported results for the third quarter Friday. The company issued a press release and filed the 10-Q report with the SEC. Wesco Financial is a publicly traded, 80% owned subsidiary of Berkshire Hathaway (BRK.A). Berkshire Hathaway also released third quarter earnings Friday.

Wesco reported net income per share of $1.39 for the third quarter and $6.01 for the first nine months of 2009 compared to $2.27 for the third quarter of 2008 and $8.21 for the first nine months of 2008. The company’s results continue to be impacted by weakness in the CORT furniture rental business and Precision Steel’s industrial businesses. In addition, investment income in 2009 has been negatively impacted by lower short term interest rates as well as reduced dividends from Wells Fargo and U.S. Bancorp. These negative developments were partially offset by improvements in underwriting results at the insurance subsidiaries.

Wesco’s balance sheet continues to show significant liquidity and little use of debt. Shareholder’s equity per share at September 30 increased to $353.78 per share, up 5.9% from $333.96 at the beginning of 2009. The increase in equity has been mainly due to increases in the fair value of Wesco’s equity investments. Let’s take a closer look at Wesco’s three reporting segments.

Insurance

Wesco’s insurance segment includes Wesco-Financial Insurance Company and Kansas Bankers Surety Company. Written reinsurance premiums for the third quarter increased by $28.6 million, or 61% over the results for the third quarter of 2008. Year to date, written reinsurance premiums increased by $32.8 million, or 14% compared to the first nine months of 2008.

Much of the difference appears to be accounted for by increases in premium volume attributable to Wesco’s participation in the reinsurance transaction between Berkshire Hathaway and Swiss Re. In 2008, Wesco entered into an agreement with National Indemnity [NICO], another Berkshire subsidiary, to assume 10% of NICO’s quota share reinsurance of Swiss Re. Earned premiums associated with the Swiss Re contract were $71.8 million for the third quarter and $203.5 million for the first nine months of 2009, which was 45.1% and 74.1% higher than the figures reported for the respective prior year periods.

Written primary insurance premiums for the third quarter were $2.4 million, a 53.1% reduction from written premium volume for the third quarter of 2008. Written primary insurance premiums for the first nine months of 2009 were $7.4 million, down 54.2% from the first nine months of 2008. This was mainly due to a decision by Kansas Bankers Surety Company to exit its line of bank deposit guarantee bonds. This decision was discussed in The Rational Walk’s coverage of Charlie Munger’s annual letter to shareholders. Mr. Munger included a detailed explanation for this decision in his letter. Our view is that the move shows considerable underwriting discipline given that bank deposit guarantee bonds accounted for a large portion of Kansas Bankers overall business.

The insurance segment posted after tax underwriting losses of $2.035 million for the third quarter, which is better than the after tax underwriting loss of $6.2 million for the third quarter of 2008. For the first nine months of 2009, after tax underwriting profits were $1.074 million compared to an underwriting loss of $4.1 million for the first nine months of 2008. As noted in the introduction, investment income has declined compared to prior year periods due to a combination of lower interest rates on cash deposits and the impact of dividend cuts at Wells Fargo and U.S. Bancorp.

Furniture Rental

CORT Business Services is the only national player in the “rent to rent” furniture industry. The business is very sensitive to overall economic conditions and business formation. Needless to say, the economic climate in 2009 has not been favorable for CORT. Segment net income for the third quarter was $18,000 compared to $5.1 million for the third quarter of 2008. For the first nine months of 2009, segment net income was $592,000 compared to $14.7 million for the first nine months of 2008. On the bright side, third quarter revenue was only down 9.9% from the third quarter of 2008 and year to date revenues were down 4.4% compared to the first nine months of 2008. The company is aggressively seeking to reduce operating expenses given uncertainty regarding the timing of a return to economic growth.

Industrial Segment

Precision Steel Warehouse and its subsidiaries posted a segment net loss of $186,000 for the third quarter compared to segment profits of $521,000 for the third quarter of 2008. For the first nine months of the year, segment loss was $859,000 compared to segment profits of $1.42 million for the first nine months of 2008. Revenues for the quarter declined 41.7% compared to the third quarter of 2008. Year to date revenues were 41.4% lower than for the first nine months of 2008. The industrial segment operates on low gross profit margins and has significant fixed operating costs. Despite management’s attempts to trim expenses, 2009 results have been poor due to decreases in revenues and high fixed costs. A return to economic growth appears to be required in order for this segment to return to solid profitability.

Wesco Common Stock Trading Below Book Value

Investors will note that Wesco’s common stock closed at $334 per share on Friday, November 6 and book value at September 30 was $353.78 per share. Since Wesco is a majority owned subsidiary of Berkshire Hathaway, many investors often compare Wesco to Berkshire. Berkshire currently trades at a premium to book value while Wesco trades at a discount. Does this make Wesco a better value than Berkshire?

Aside from the fact that the two companies are vastly different in terms of business activities and investments and simply cannot be directly compared, investors should note what Charlie Munger had to say about this question in his latest letter to shareholders published on February 25, 2009:

Business and human quality in place at Wesco continues to be not nearly as good, all factors considered, as that in place at Berkshire Hathaway. Wesco is not an equally-good-but- smaller version of Berkshire Hathaway, better because its small size makes growth easier. Instead, each dollar of book value at Wesco continues plainly to provide much less intrinsic value than a similar dollar of book value at Berkshire Hathaway. Moreover, the quality disparity in book value’s intrinsic merits has, in recent years, continued to widen in favor of Berkshire Hathaway.

All that said, we make no attempt to appraise relative attractiveness for investment of Wesco versus Berkshire Hathaway stock at present stock-market quotations.

Disclosure: The author has no direct position in Wesco common stock. However, the author owns shares of Berkshire Hathaway which owns 80% of Wesco.

Comments

[UncleLongHair:]

You forgot to mention what I consider to be the most interesting thing about the current situation at WSC, which is their investment in Goldman Sachs. That investment, made during the depths of the crisis, looks to be a home run, with preferred stock paying a 10% coupon plus warrants with a strike price of $115. Goldman's current stock price is about $170, putting the warrants way in the money.

WSC is much more exposed to the Goldman investment than Berkshire, as about 11% of its investment portfolio is the Goldman preferred, forgetting about the warrants. The warrants are probably worth at least 50% the value of the preferred, depending on how you value them. With a 5 year period they have a lot of time value left.

WSC as it is today is fairly uninteresting and has nowhere near the earnings power of Berkshire. However there is no reason for it to trade at a discount to book, it should trade at a small premium as it has for most of its recent history.

Nov 09 09:12 AM

[Ravi Nagarajan:]

On Nov 09 09:12 AM UncleLongHair wrote:

> You forgot to mention what I consider to be the most interesting
> thing about the current situation at WSC, which is their investment
> in Goldman Sachs.

Good point - Wesco did get a piece of that deal and it has helped investment income. However, the positive income of the GS investment appears to have been more than offset by declines in dividend income due to dividend cuts at WFC and US Bancorp as well as lower interest rates in general.

I do agree that there seems little reason for Wesco to trade below book value. Furthermore, at Friday's close, Wesco was not that far above tangible book value (backing out the goodwill).

If I didn't already have significant exposure to Wesco via Berkshire, I would more seriously consider purchasing shares directly if we have further declines, particularly below tangible book.

Nov 09 09:26 AM

[UncleLongHair:]

Something which differentiates Wesco from Berkshire is that I think it is primarily a book value story. Wesco does not have much earnings power relative to its asset base, which is dominated by investments and cash. The operating subs are almost ancillary to its net worth and intrinsic value. The warrants from the Goldman investment produce no income but will likely have a significant positive impact on book value.

Owning Berkshire, you have very little exposure to Wesco, as Wesco's market value is about 1.5% of Berkshire's. If 10% of your portfolio is in Berkshire, then 0.15% of it is in Wesco. I think that buying Wesco below book is at least as interesting as owning Berkshire at 1.4-1.5x book, perhaps moreso. Wesco is basically a slightly leveraged portfolio of blue chip stocks hand-picked by Munger.

I am wondering if the Burlington deal will affect Wesco in any way. It does not appear that Wesco owned any stock in Burlington before the deal. It is conceivable that some of Wesco's cash will go towards the cash portion of the deal, which would be accretive to Wesco, but that is only a guess.

Nov 09 01:35 PM