E-L FINANCIAL CORPORATION LIMITED
E-L Financial's stock has had a nice
run over the past twelve months, increasing from a low of $220 to reach a
high of $350 in February. The insurance industry has experienced good
pricing power over the past year and this has fueled the run in both life
and property and casualty insurance stocks. In 2003 the Company reported
net operating income (before investment gains) of $11.17 per share
compared to $6.08 per share in 2002. Including investment gains, ELF
reported earnings of $12.20 compared to $12.40 the previous period. We
believe that the reduced reliance on investment gains indicate that 2003
earnings are of higher quality compared to last year. Book value, after
payment of the small $0.50 per share dividend, has grown to approximately
$350 per share.
Examining segmented data, we see that
the Dominion of Canada General Insurance Company's revenue increased 25%
to reach $962.9 million and the Empire Life Insurance Company's revenue
increased approximately 15% to reach $668.9 million. Net income for the
general insurance segment declined 8.5% to $20.3 million. Earnings for
this division were negatively impacted when ELF realized a loss on
investments of $13.3 million for the year. Excluding this loss, general
insurance earnings would have totaled $33.6 million, implying a growth
rate of 52%. This demonstrates a unique aspect of the insurance industry;
investment gains and losses are part of the normal course of business but
the timing decision lies with management. Net earnings in the life
insurance division showed a 21.4% increase to reach $14.1 million for the
year.
Although the Company has yet to
announce any major initiatives, the market has at least begun to notice
this undervalued stock. Now that the discount to book value has closed, we
expect that the discount to NAV will continue to narrow. We believe that
ELF's net asset value could fall within a range of $450 to $500 per share
but it is difficult to be more precise in our estimate. Should Empire Life
be put up for sale, a bidding war for one of the last free-standing life
insurers could result in a significant premium to book value. As long as
insurance pricing remains firm and the stock market holds its gains, ELF
should continue to perform well.
PRIME HOSPITALITY CORPORATION
Prime Hospitality Corp (PDQ). is an
owner, manager and franchisor of hotels. It currently operates 245 hotels,
containing 31,426 rooms located in 33 states. Prime controls two hotel
brands, AmeriSuites, which are upscale all-suites hotels, and Wellesley
Inns & Suites, which are mid-price limited service hotels. The company
also operates a portfolio of upscale, full-service hotels under franchise
agreements with national hotel chains. PDQ is in the midst of transforming
itself from a hotel owner/operator to a franchisor and manager of hotel
brands. We believe that this strategy is good for shareholders for a
number of reasons. First, by selling its land and hotels, PDQ is unlocking
the illiquid real estate value that is not fully reflected in its stock
price. Second, the company can use the proceeds to pay down debt and
repurchase shares. Finally, this strategy will allow the company to focus
entirely on its key strengths: managing and growing the AmeriSuites,
Wellesley, and Prime brands.
Despite a nearly two-fold increase in
price in the last twelve months, shares of PDQ continue to trade below
their book value, replacement cost and net asset value. On March 5th,
Extended Stay America, a publicly traded operator of hotels, agreed to be
purchased by buyout firm Blackstone Group for $19.625 per share. This
price, represented a 25% premium over the previous days closing price and
translates to a purchase price of about $61,000 per room. Shares of PDQ,
which offers comparable, if not more upscale rooms and services, are
currently trading at approximately $45,000 per room. In fact, PDQ has
recently sold hotels for between $80-85,000 per room.
We feel this transaction not only sets
a precedent for asset values in the industry, but also highlights PDQ's
significant market undervaluation. This fact could become a major positive
catalyst toward a meaningful appreciation of PDQ shares. Also, investors
should keep in mind that PDQ, like Extended Stay America, could become a
takeover target in the future. Given that PDQ CEO A.F. Petrocelli controls
over 3.5 million shares of the company, we believe a large incentive
exists for him to sell the company, preferably at or above its net asset
value.
SEARS CANADA INCORPORATED
Sears Canada, the well-known Canadian
retailer, operates 123 department stores, 47 furniture and appliance
stores, 145 dealer stores, 14 outlet stores, 49 floor covering centers and
110 travel offices. The Company publishes a catalog with a circulation of
4 million households, supported by three call centers and over 2,200
pick-up locations. Sears Canada is 54% owned by Sears, Roebuck and Co. of
Chicago, Illinois.
On December 11, 2003 Sears revised its
earnings guidance for fiscal 2003 due to weak apparel sales. The Company
reduced EPS expectations from a range of $1.40 to $1.60 to a range of only
$1.10 to $1.20. The next day the stock dropped approximately 13.5% on the
news. We believed that the sell-off was overdone and began to accumulate
stock around the Company's third quarter book value of $16.11. When the
stock was halted on January 8, 2004 our instinct was validated when the
Company stated that due to a late year sales surge they expected to exceed
the lowered earnings guidance.
In addition to the better than
originally anticipated Christmas season, we believe that investors have
overlooked some potentially valuable assets within the Company. Sears
Canada has a wholly owned subsidiary SLH Transport that offers
transportation and logistics services across Canada and some parts of the
United States. The Company has 625 trucks, 3,400 trailers, 1,500 full and
part time employees and 380 owner-operators. SLH Transport has over 300
third party customers, in addition to Sears Canada. We believe that SLH
Transport could be worth more than $3.50 per share net of debt to Sears
Canada, based on other publicly traded trucking companies.
Sears has also created shareholder
value by establishing a greater presence in financial services. The
Company already has 9.2 million credit cards in circulation and 4.2
million active accounts. More than 75% of households in Canada have a
Sears Card, which represents the largest single card franchise in Canada.
On December 15, 2003 Sears Canada received approval to commence operations
as a Bank. Sears Canada will continue to offer its Sears Card and could
potentially offer such services as mortgages and personal lines of credit
through Sears Canada Bank. The Company plans to focus on converting
inactive Sears Card holders to the Sears MasterCard. Eventually there is
the possibility of selling the original Sears Card operations, just as
Sears Roebuck did this past year.
Our investment thesis for Sears Canada
is quite simple. The stock reached oversold levels after disappointing
earnings guidance, which was subsequently revised upward. Downside
protection is provided by the current book value of $16.96 and the
possibility of Sears Roebuck taking out the entire Company should the
share price remain depressed. Finally, we see hidden value in the
Company's trucking division, credit card operations, the recently created
Sears Canada Bank and approximately $320 million of real estate. In a
nutshell, Sears Canada fit in well with our deep value philosophy.
SHERMAG INCORPORATED
Shermag, like many other Canadian
manufacturers, has been hit by fears of a rising Canadian dollar. Faced
with a difficult situation, management made the strategic decision to
protect its hard-won share of the competitive U.S. furniture market. The
Company refused to raise its prices, which led to lower Canadian dollar
dominated revenues. This, in turn, compressed margins, despite a foreign
currency hedging program and aggressive cost containment. As a result,
Shermag was forced to revise its earnings guidance on January 26 of this
year and the Company's shares subsequently declined below $12 before
stabilizing around $13.
When Shermag released its results on
February 20, we were able to get a more complete picture of the Company's
financial health. For the third quarter, the Company earned $0.26 per
share compared to $0.32 per share last year. For the first nine months,
Shermag earned $0.96 per share and seems on track to earn between $1.20
and $1.30 per share for the year. Shermag's operating activities have
generated $7.1 million in cash flow over the first nine months of the
current fiscal year despite consuming $400,000 in the third quarter. The
balance sheet remains conservatively capitalized, with a debt to equity
ratio of only 0.3 times.
We believe that the mid to long-term
outlook for the Company remains strong. Record low interest rates have
fuelled a housing boom that, in turn, has driven furniture sales. In fact,
retail furniture sales have been increasing steadily since February of
2003, according to the U.S. Department of Commerce's Advance Monthly Sales
for Retail Trade and Food Services Report. We look for this trend to
continue for some time, since furniture sales generally lag new home sales
by several months. We believe that if the stock continues to trade at only
10 times forward earnings, the Company will use its cash flow to buy back
stock, pay a dividend or make another small but accretive acquisition.
Irwin A. Michael, CFA
