Fairfax Financial Works Up a $1.4 Billion Deal for Zenith National

As a resident of California, the economic situation I see around me is still awful. It's hard to see how things will come back.But for long-term players, the downturn may be an opportunity. Fairfax Financial, a Canadian property and casualty insurance provider, has agreed to pay $1.4 billion for California workers compensation insurer Zenith National Insurance (ZNT). The $38-per-share deal comes at a 31.4% premium, and to pull it off, Fairfax plans to raise $200 million in an equity offering.

The insurance business is fairly cyclical, and the downward trend has been exaggerated in the past two years, especially in hard-hit places like California. So for Fairfax, this could ultimately be a lucrative play.

A Look at Zenith

Founded nearly 40 years ago, Zenith is now a top player in workers compensation insurance that is required by state statute. While the company operates in 45 states, roughly 80% of its revenues come from California and Florida.

Despite the recession, Zenith has been able to push forward. In its latest quarterly report, the company posted net income of $10.8 million, or $0.29 per share. For the full-year, net income was $34.4 million, or $0.91 per share. It helps that the company has a strong risk-management approach and a good customer base, with 29,600 policyholders. Zenith has also restructured its operations, with layoffs that trimmed away 13% of its workforce.

But the rising unemployment rate and health costs have resulted in lower gross premiums and put pressure on growth (last year, policies in-force fell by 14%). In other words, Zenith will need the U.S. economy to make a comeback before it can rebound.

Timing is Everything

Fairfax CEO Prem Watsa has proven to be a savvy deal-maker. The company's founder, he built it up in a similar fashion to the way Warren Buffett grew Berkshire Hathaway (BRK.A) and the Tisch family built Loews (L): by making insightful investments with the assets from its insurance business, often betting on dark-horse securities. In fact, Watsa's nickname is the "Canadian Warren Buffett."

One of his recent moves nicely illustrates that: The company made more than $2 billion on credit default swaps, which surged in value because of the global financial meltdown. Fairfax also saw a variety of its equity investments generate substantial returns.

With its CDS windfall, Fairfax has gone shopping: It recently made a $1 billion deal for the 27% of Odyssey Re Holdings it did not already own. And even after the purchase of Zenith, Fairfax will still have $1 billion in extra capital, enough to make some other deals that will take advantage of the current low valuations and the anticipated growth phase of the insurance cycle.
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