Profitable Net-Net Mid Cap: Allied World Assurance

| About: Allied World (AWH)

Since I last wrote about Allied World Assurance (NYSE:AWH), there has been almost zero movement in the share price. Currently the price is $63.50 or a market cap of $2.54B on 40M shares fully outstanding. They have $9.7B in cash and equivalents against $7.35B in total liabilities. This gives an enterprise value (EV) of less than $10 million dollars.

This is basically the net price you would pay if you were buying the entire company at today's share price. Including the most recent press release from April 12, 2011 gives an initial estimate of $75M in damages in Japan. This brings EV to $85M which may turn negative on May 4th, 2011 when AWH reports 1st quarter results. I don't believe there is much risk moving forward.

I don't believe I mentioned management much in the previous post but I am beginning to think that they are one of the best run companies in America currently. I like that investor presentations are released at least quarterly and the 10ks are very detailed. Share awards or stock bonuses are given out sparsely and account for a mere fraction (>$40M) compared to total buybacks of $1.1B which is especially intelligent considering they were buying their company back for less than $100M.

According to the latest presentation released (March 2011) 5-Year Return on Equity is 20.3% so they lead the insurance industry by 200 bps and Markel by 6%.5-Year growth in book value is 143% which beats the closest competitors Endurance (108%) and Markel (60%). Their Float of $8B against $1.6B in premiums in 2010 is a ratio of 5 which trumps Berkshire Hathaway's (NYSE:BRK.A) insurance segment at a 3.1 ratio. Total Loss Reserves, whose fluctuations are what cause AIG-type meltdowns, compared to Total equity is in ratio of 1.28:1. This shows that AWH has significant liquidity when facing damages such as Japan recently. They also have the capability of withstanding up to $1B in damages from an extreme earthquake in California. If you purchase at the current price you would have significant margin of safety to withstand such a loss and still have a profitable investment. There is a current trend expecting increased premiums in the future as opposed to the decreased premiums AWH expects (another example of honesty with shareholders) moving forward. Due to the significant amount of Earthquakes and the recent disaster in Japan, many insurance analysts expect increased premiums for casualty. AWH currently has "excellent" credit from A.M. Best.

I also see AWH as a bet for increased inflation in the future. Increased inflation will suggest proportional increases in premiums and wages leaving the underwriting profit flat. Investment income would likely increase more than inflation due to the amount of cash ($900M) and recent senior-debt ($300M) for a total of $1.2B and over $2B in marketable securities maturing in the next 12 months. All this money would presumably be reinvested at high interest rates and raising net income. Management has sacrificed some present interest yield for significant liquidity currently and increasing in the near future. Combined ratio is consistently below 85% compared to Chubb (NYSE:CB) with 89.3%, Endurance (NYSE:ENH) 88.7%, Markel (NYSE:MKL) 99%.

Warren Buffett valued GEICO in 1980, which had negative equity at the time, by consider normalized earnings. Normalized earnings are underwriting income + investment income. Underwriting income is (1-.85)*($1.5B total premiums) = $225M. Investment income is 4.3%*($8B) = $345B. Losses from significant events have averaged approximately $100M since going public which gives normalized earnings of $470M annually. This gives a value for the insurance company of $2.45B net cash + $4.7B insurance company = $7.15B present value. Or using total equity of $3B giving a present value of AWH of $7.7B.
At a $7.7B present value AWH is currently priced at just 33.25% of its intrinsic value! This is an intrinsic value of $192.50 which would fully price Allied World Assurance.


May 4, 2011 earnings

Disclosure: I am long AWH.

Additional disclosure: I am not long any of the other companies mentioned.

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