Steve is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
With echoes of Berkshire Hathaway's(NYSE: BRK-A)(NYSE: BRK-B) 2009 Burlington Northern deal, Markel(NYSE: MKL) this morning announced its largest acquisition to date with a $3 billion cash and stock agreement to buy rival Alterra Capital Holdings(NASDAQ: ALTE).
The offer, which converts each common share of Alterra into a right to receive 0.04315 shares of Markel and a cash payment of $10, valued ALTE at $31 per share based on Markel's closing price Tuesday. After the merger, Markel shareholders will own approximately 69% of the combined company.
While shares of ALTE initially popped more than 34% on the news, shares of MKL are trading down 9% as analysts worry Markel has bitten off more than it can chew.
Is Markel in over its head?
Given Markel's relatively small market capitalization of $4.6 billion, I recently noted the company typically looks to acquire "small, efficient, money-making businesses with disciplined management and high insider ownership [while using] little or no debt and with 'no plans for an exit in the future.'" More specifically, through its Markel Ventures subsidiary, company President and CIO Tom Gayner likes to look for companies with annual revenue between $25 and $250 million, EBITDA from $5 to $50 million, and an enterprise value from $25 to $300 million.
Today's announcement, then, is a radical departure from Markel's norm. In acquiring Alterra, Markel has bagged a company with annual revenue of $1.65 billion, EBITDA of $259 million, and an enterprise value of $1.88 billion. In addition, given Alterra's 95.98 million shares outstanding, the cash portion of the deal will cost Markel more than 60% of its $1.6 billion in cash, cash equivalents, and short-term investments.
Stifel Nicolaus analyst Meyer Shields wasted no time voicing skepticism for the deal, reminding investors of the troubles Markel experienced with its last major acquisition of Terra Nova in 2000. The criticism is fair enough; after Markel initially offered to pay $905 million in cash and stock for the company in July 1999, Terra Nova unexpectedly revealed heavy losses due to catastrophe claims in the following quarter from its European markets. While Markel was lucky the timing of the deal allowed it to lower the buyout offer to $670 million, it was left wiping egg off its face as a result of the close call.
Was it worth it?
Despite Markel's rocky past with large acquisitions, however, as we dig deeper it's easy to see why the company is willing to pay up for Alterra today.
With its deep bench of experienced management, Alterra has an excellent track record of providing value in the insurance and reinsurance markets and currently pays a 2.8% dividend with a conservative payout ratio of 26%. Nearly 20% of ALTE's float is held by insiders, and the company is solidly profitable as it achieves healthy operating margins of 15.55% and net margins at 13.71%. In addition, it manages respectable returns on invested capital of 6.7% and, as of yesterday's close, shares were undeniably cheap at 10.5 times trailing earnings. Even after today's pop, the stock still trades below its per share book value of $30.45 with a current P/E ratio under 13.
In addition to expanding Markel's insurance and reinsurance operations, Alterra could also provide the resources Markel needs to be able to prudently invest both its float and shareholder equity as Berkshire Hathaway does. As I mentioned in October, Markel's relatively small size currently only allows it to responsibly invest shareholder equity. While analysts may not have confidence in Markel's acquisition record, they're unanimous in the belief that putting more investment money in the proven hands of Tom Gayner is a great idea.
Foolish bottom line
Though Markel's biggest acquisition to date may make investors nervous, Alterra's fundamentals are solid and I'm convinced Markel didn't check its usual prudence at the door to make this deal happen. In the end, patient long-term investors should view today's pullback as a fantastic buying opportunity.