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Fairfax vs. The Shorts


Fairfax Financial Holdings (FFH) Ltd. says it sees shares of struggling Overstock.com Inc. (OSTK) as a bargain. But it's pretty clear that there's more to Fairfax' interest in the online retailer than that.

Since February, Fairfax, a Toronto insurer, has emerged as Overstock's biggest outside backer. With the addition of nearly a million shares in early May, Fairfax now owns 11.5% of Overstock, worth $50 million. The latest buy gave Overstock a cash infusion it badly needed and fueled speculation about an alliance between its CEO, Patrick M. Byrne, a vociferous critic of short-sellers, and Fairfax CEO V. Prem Watsa, who has faced his own long battle against the shorts.

Watsa, who during happier times in the early 1990s heard himself called "the Warren Buffett of the North," believes that Overstock's beaten-down shares now simply represent good value. But with roughly 3 million, or 18%, of Fairfax' own shares sold short, Watsa sympathizes with Byrne's pronouncements that short-sellers and certain research analysts have unfairly targeted Overstock. "We look at their experience and see similarities," says Watsa. "We don't know why this is happening to us."

RED INK

Short-sellers, who bet on shares slumping, have a simple answer. They see in Fairfax a highly leveraged company that has racked up nothing but red ink in its core insurance-underwriting business while using what they call a host of accounting gimmicks to make its financials appear stronger than they are. Twice in recent years, Fairfax has also sold shares below book value to shore up its cash, a move that normally signals extreme weakness. In the face of government investigations, shareholder lawsuits, and losses that soared to $498 million last year, Fairfax can't continue the juggling forever, these skeptics say. "Ultimately, I simply don't believe they have the capital to pay their claims," says one short-seller, whose interest, to be sure, is served by such comments. "If they can't keep raising money, it's the end of their story."

Watsa, 55, vehemently disagrees. He says Fairfax has adequate funding, and its dealings are fully disclosed. The company, he adds, has plenty of financing options and a band of loyal long-term backers who control the majority of its shares. These include well-known value investors Mason Hawkins of Southeastern Asset Management Inc. and Peter Cundill & Associates. Wade S. Burton, a portfolio manager at Cundill, sees the Fairfax saga coming to a head, but with a cheerful outcome. With first quarter earnings up fivefold, to $172 million, he says, "This is going to be a very good year for them."

A native of Hyderabad, India's fifth-largest city, Watsa formed Fairfax in 1985 and modeled himself after Buffett. He bought a series of insurers and churned out big investment gains on the premiums they generated. By 1999, the value of Fairfax' Canadian shares in U.S. dollars soared from just over $2 to more than $400.

But in the rush to acquire, Watsa gobbled up several weak U.S. property and casualty insurers in the late '90s that were hit hard when the industry faced a price war and rising claims in areas such as asbestos and workers' compensation. The strain of paying off debt from buying those companies and the continuing losses from their claims have hobbled Fairfax ever since. After it listed on the New York Stock Exchange in late 2002, the shorts piled in. Hefty payouts for horrific hurricanes in the past two years added to its woes. Fairfax shares now trade for around $112 on the NYSE.

Watsa acknowledges that Fairfax has taken longer to resolve these problems than expected. But after years of restructuring, he says Fairfax now boasts far better underwriting profitability at key operating units such as Crum & Forster Holdings Corp. and Northbridge Financial Corp., respectively its main U.S. and Canadian insurance subsidiaries, and Odyssey Re Holdings Corp. (ORH), a reinsurance unit. "That's why we think the next five years will be significantly better than the last," he says.

But its critics argue that Fairfax' numbers raise as many questions as they answer. For one, they believe that Watsa, by focusing on Fairfax' current operating units, overstates the extent of the company's turnaround. John Gwynn, an analyst at the small investment banking and brokerage firm Morgan Keegan & Co., argues that many of the underlying problems remain. They've simply been shifted elsewhere in Fairfax' complex structure, says Gwynn, a longtime critic of the company whose employer doesn't have a financial stake in Fairfax.

Many of the insurer's worst-performing businesses have been shut down and moved into companies known as "runoff" units. That's insurance-speak for companies that no longer write new policies. Problem is, runoff companies still have to pay claims from old policies. That's a key reason why Fairfax' biggest money-losing division in recent years, and the source of a huge cash drain, has been the one containing its runoff units.

Watsa argues that those losses are now under control. He says runoff operations will come close to breakeven this year, barring unusual items.

Questions have also been raised about whether Fairfax has buffed up its financial results through extensive use of "finite risk" reinsurance, the controversial product at the heart of current industry investigations by the Securities & Exchange Commission and the Justice Dept. Investigators are probing transactions in which Fairfax and a number of other insurers have transferred claims to reinsurance units in exchange for cash premiums. If the reinsurance units truly could end up paying on claims, these finite-risk deals may be legitimate. If there isn't genuine risk of having to pay, the deals can be seen as more like loans -- and may have been used to make the insurers' earnings and capital appear stronger than they are.

After providing the SEC with a review of its finite contracts last fall, Fairfax revealed in March that the company, external auditors PricewaterhouseCoopers, and Watsa himself recently received additional subpoenas. Separately, investigators also appear to be looking into transactions involving Fairfax shares, but the details of that line of inquiry aren't clear. Fairfax has denied any wrongdoing. PricewaterhouseCoopers declined to comment.

Following its review, Fairfax' Odyssey unit restated recent earnings to correct for accounting errors in reinsurance contracts; another subsidiary made changes that were immaterial to Fairfax. Watsa says the restatements are complete and its remaining deals are properly accounted for. Despite the controversy over finite reinsurance, he argues that the technique protects his company's balance sheet against the higher-than-expected losses still coming in from the acquisitions.

The year ahead is critical. Watsa knows he must deliver on his long-delayed turnaround if he wants to bring the battle with the shorts to a close. Unlike Overstock's Byrne, who has sued his critics, Watsa says he has no interest in going to court. "Ultimately, results will out," he says. The short-sellers agree.

By Jane Sasseen


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