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Happy Chinese New Year from Toronto, where the temperature has fluctuated between a balmy +11°C
(52°F) and a frigid -19°C (-2°F). As part of our real job, we had the opportunity to sit down with the
famous value investor Prem Watsa (Disclosure: Fairfax Financial Holdings Inc. is part of our research
coverage). While we cannot divulge the details of our conversations with Prem, we can confirm that
Prem continues to be very cautious regarding the current market rally, citing risks such as a Chinese
housing bubble, the European debt crisis and high unemployment in the U.S. At the end of the third
quarter, Fairfax had approximately 90% of its equity exposure hedged through index swaps and have
also hedged the entire business against deflation! Kind of makes you wonder if the current rally is
sustainable?

Speaking of the weather, is it not strange that the U.S. Northeast has suffered 5 major snow storms this
season and it is only February? Not to mention the wild swings in weather across the globe, from floods
in Australia and Pakistan to droughts in the American Midwest. In our opinion, this may be only a
preview of more weather volatility to come as a result of global warming; an increase in global
temperatures increases the energy in the system which causes greater volatility.

For disbelievers of global warming, you may want to ask yourself whether you can claim, with 100%
certainty, that global warming does not exist? Even IF the probability of global warming is only one in a
trillion billion, the fact that if global warming IS true, the eventual loss to society would be INFINITE
(since it would lead to our extinction) implies the expected loss to be INFINITE. Are we willing to make
that bet?

But we digress. This letter is not an appropriate forum to discuss global warming. In this month’s letter,
we wish to discuss earnings power and margin of safety in the context of U.S. tobacco stocks. We will
also discuss our thoughts on inflation and a recent addition to our portfolio, Hilltop Holdings Inc. (HTH-
NYSE).

Let us dive in!

Jason Chen
The Aspiring Analyst

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Earnings Power And Margin Of Safety; Time For A Smoke?

In the last couple of months, U.S. tobacco stocks have taken a hard drubbing as the investors worry
about the fallout from the ongoing FDA Tobacco Products Scientific Advisory Committee (TPSAC) public
hearings on the impact of menthol in cigarettes on public health and other tobacco-related topics. Of
most concern to tobacco stocks is the hearings and recommendations on menthol in cigarettes, as
menthol have been one of the few growth areas in a shrinking industry. The basic charge is that the
‘cool’ sensation of menthol helps mask the bitterness of cigarettes and thus encourages smokers to
breathe more deeply, inhaling more cancer-laden smoke. There is also concern that menthol cigarettes
seem to disproportionately target minorities. The committee’s full report and recommendations are
expected by March 23, and in a worst-case scenario, TPSAC may recommend to the FDA to ban the use
of menthol in cigarettes.

One company that has been hit particularly hard is Lorillard Inc. (LO-NYSE). Lorillard, the 3rd largest
tobacco company in the U.S., is somewhat of a one-trick pony as its Newport brand of menthol
cigarettes account for over 90% of the Company’s revenues. From a high of almost $90 per share, it has
fallen by 15% to the $75 level. It attracted our attention because at its current price, it sports an
estimated 6% dividend yield. Is now a good time to buy tobacco stocks, in particular Lorillard?

Putting aside the moral issue of whether buying tobacco stocks is akin to condoning the act of smoking,
it appears cigarette manufacturing has rewarded shareholders well. Did you know that Altria (MO-
NYSE), Philip Morris (PM-NYSE), Reynolds America (RAI-NYSE) and Lorillard all have extremely high gross
margins (45%+), even after accounting for excise taxes? That collectively, these four companies have
paid $42 BB in dividends and bought back almost $14 BB in stock in the five years to 2009? That Ben
Bernanke’s only stock holding was Altria?

A preliminary strategic analysis (using Porter’s 5 Forces) would suggest cigarette manufacturing is as
good a business as they come. Nicotine addiction makes buyers insensitive to price; the main
ingredients to a cigarette is just paper and tobacco leaves (both commodities that can be bought and
sold with relative ease); and there is no real substitute for cigarettes. This creates an almost perfect
environment for maximum value creation (see Figure 1). Despite what industry participants say, there
cannot be true rivalry and competition when the industry participants earn in excess of 20% net
margins. The threat of government regulations and potential fines means also act as a strong barrier to
entry, leading to a perfect environment for maximum value extraction also.

Moving on from the industry analysis, let’s consider LO’s stock valuation. As value investors, we prefer
to look at a company’s earnings power, or what we believe the company’s earnings are worth (Looking
at the asset values may also be appropriate for tobacco companies, particularly for a company like Altria
which owns almost 29% of SABMiller).

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Figure 1: Porter's Five Forces.

For example, let us consider Lorillard’s simplified income statement

statement:

Income Statement
For the Fiscal Period Ending 12 months 12 m onths 12 m onths 12 m onths 12 months 12 months LTM
Dec-31-2004 Dec-31-2005 Dec-31-2006 Dec-31-2007 Dec-31-2008 Dec-31-2009 Sep-30-2010

Total Revenue 2,690.0 2,892.0 3,056.0 3,281.0 3,492.0 3,686.0 3,965.0

Gross Profit 1,382.0 1,454.0 1,595.0 1,656.0 1,770.0 1,906.0 2,066.0

Operating Income 1,001.0 1,167.0 1,318.0 1,395.0 1,513.0 1,639.0 1,788.0

Net Interest Exp. 19.0 54.0 78.0 109.0 19.0 (22.0) (71.0)

EBT Incl. Unusual Items 1,039.0 1,151.0 1,344.0 1,383.0 1,434.0 1,519.0 1,619.0

Income Tax Expense 397.0 445.0 518.0 485.0 547.0 571.0 607.0
Net Income 642.0 706.0 826.0 898.0 887.0 948.0 1,012.0

Diluted EPS $3.69 $4.059 $4.75 $5.16 $5.15 $5.76 $6.559

Figure 2:: Lorillard Simplified Income Statement. Source: Capital IQ

We can see that the Company has been a fairly consistent earner
earner, recession-proof,
proof, even.
even Let us assume
that LO can earn an operating income of $1.8 BB or generate e approximately $1.1 BB in free cash flow
(see Figure 3) into perpetuity. (We can also build a full financial model and estimate the free cash flow
for 3, 5, 7 years into the future, but that would be overkill for this example
example). What is the stream of
perpetual cash flows worth?? (As a side note, ffigure 3 also demonstrates the economics of the tobacco
business, as Lorillard has practically no capital expenditure needs – it only has one manufacturing facility
in North Carolina).

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EBIT 1,788
Tax Rate 37.50%
EBIT (1-T) 1,118
+Depreciation 39
-CapEX (42)
∆NWC -
Unlevered FCF 1,114

Figure 3: Normalized FCF Calculation.

To find the earnings power of Lorillard’s business, we discount the normalized free cash flow by an
appropriate cost of capital (For those not familiar Discounted Cash Flow Valuations, Professor Aswath
Damodaran from NYU has a great website devoted to finance and valuations:
http://pages.stern.nyu.edu/~adamodar/). Note that if we were to use the standard investment banking
formula to calculate Lorillard’s weighted average cost of capital (WACC), we would come up with a
discount rate of approximately 6.0% (β of 0.49, Rf of 3.3%, MRP of 6%, 4.75% after-tax cost of debt, 14%
debt/equity). We believe this is far too low, given the risk embedded in Lorillard’s business (the risk of
class action lawsuits and additional government regulations come to mind). Instead of discounting with
a suspect discount rate, we prefer to look at the valuation over a range of discount rates (see Figure 4).
As can be seen from the table, if Lorillard were able to earn $1.1 BB in free cash flow into perpetuity, we
would consider Lorillard attractively valued at discount rates below 10%.

FCF 1,114 WACC Sensitivity

WACC 8% 6% 7% 8% 9% 10%
EV ($MM) 13,926 18,568 15,915 13,926 12,379 11,141
Less: Net Debt (296)
Equity Value 14,222
Shares O/S 149.6
Price 95.06 126.09 108.36 95.06 84.72 76.44

Figure 4: Calculation of Enterprise Value & Stock Value.

Does this mean Lorillard is undervalued, given the market WACC is 6%, which would imply a value of
$126 on the stock? Not exactly. Recall above, we assumed that free cash flows would be $1.1 BB in
perpetuity. In reality, tobacco is a business in terminal decline. Even if Lorillard is able to gain market
share via its Newport brand of menthol cigarettes, the whole industry is shrinking. For a perpetuity with
ி஼ி
negative growth rates, the valuation formula is ‫ = ܸܧ‬ௐ஺஼஼ି௚, which effectively increases the discount
rate. Let us assume a terminal growth rate of -2%, this would imply Lorillard’s value is closer to $95 and
not $126. Moreover, we do not know the impact of the TPSAC’s recommendations to the FDA. At the
very least, we might expect the FDA to impose tougher regulations on marketing or packaging of
menthol cigarettes. More draconian measures may include changing the formulation (and hence taste)
of menthol cigarettes or an outright ban. Figure 5 looks at the impact to valuation of a 10%, 25% and
75% reduction in the free cash flow.

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90% 70% 25%

EBIT 1,788 1,609 1,252 447
Tax Rate 37.50% 37.50% 37.50% 37.50%
EBIT (1-T) 1,118 1,006 782 279
+Depreciation 39 39 39 39
-CapEX (42) (42) (42) (42)
∆NWC - - - -
Unlevered FCF 1,114 1,002 779 276

FCF 1,114 1,002 779 276

WACC 8% 8% 8% 8%
EV ($MM) 13,926 12,529 9,735 3,449
Less: Net Debt (296) (296) (296) (296)
Equity Value 14,222 12,825 10,031 3,745
Shares O/S 149.6 149.6 149.6 149.6
Price 95.06 85.72 67.05 25.03

Figure 5: Sensitivity Of Implied Value To Reduction In Business.

What is the probability of those scenarios? We do not know, but we do know they are not zero. If we
venture forth the probabilities shown in Figure 6, then the expected value falls to approximately $80 for
a miniscule 8% margin of safety. Notice all the adjustments we have made so far have been negative to
value. In fact, we think of Lorillard as having upside of approximately 27% or $95 but with significant
downside that can come from a multitude of factors, ranging from a miscalculation of the discount rate,
a faster decline in the smoking population or tougher than expected government regulations.

Price 95.06 85.72 67.05 25.03

Probability 25% 50% 20% 5%
Expected Value 81.29
Margin of Safety 8%
Current Price 75.00

Figure 6: Expected Value & Margin Of Safety.

In conclusion, we do not think Lorillard is a good investment despite the attractive 6% dividend yield and
recession-proof business model. In general, we prefer investments in securities with large margins of
safety and more upside risk than downside surprises. We think the relatively small margin of safety does
not adequately compensate us for the large risks that we are taking. (On the other hand, if on March 23,
the TPSAC recommends a complete ban on menthol cigarettes and Lorillard’s stock price plummets to
$25, we may reconsider our position since at that point, there would be more upside surprises such as a
potentially drawn out implementation process to the complete ban.)

Inflation Does Not Matter...If You Do Not Drive, Eat Or Heat Your Home

We recently read Ben Bernanke’s speech on economic outlook and macroeconomic policy
(http://www.federalreserve.gov/newsevents/speech/bernanke20110203a.htm) where he once again
reiterated that overall inflation remains quite low, despite the rapid rise in the price of gasoline and food
prices globally. Central bankers in general like to focus on ‘core’ inflation, an inflation rate that ignores

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volatile items such as food and energy prices. We would like to invite central bankers to return to the
real world where people have to eat, drive and heat their homes.

In fact, we are beginning to think another key risk to the world economy is runaway inflation caused by
the commodity asset bubble inflated by cheap credit. Anecdotal evidence supports our view that
inflation is much higher than the 0.7% core inflation cited by Mr. Bernanke and is a far bigger problem
than many realize:

• McDonald’s recently announced price increases to some menu items to offset rising input costs
(http://articles.latimes.com/2011/jan/24/business/la-fi-0125-mcdonalds-20110124)
• Appliance manufacturers Whirlpool and Electrolux recently announced they would be raising
prices significantly in an effort to offset the rising cost of steel and other inputs
(http://www.reuters.com/article/2011/02/02/us-whirlpool-idUSTRE7112UR20110202)
• The doubling in price of onions in India (a staple in Indian cooking) leading to an ‘onion crisis’
(http://www.ft.com/cms/s/0/5ae4ddb0-0dca-11e0-8b53-00144feabdc0.html#axzz1CwUFfddL)
• A similar ‘chili crisis’ in Indonesia (http://www.bloomberg.com/news/2011-02-02/chili-peppers-
indicate-inflation-heating-up-commentary-by-william-pesek.html)
• And many more...

We think there are serious implications to commodity bubbles and runaway for investors. First of all,
there will be a short-term squeeze on profit margins, as there is usually a lag before businesses can pass
on additional costs to customers. Moreover, rising prices can put a serious crimp on consumer spending
(and hence GDP growth), as consumers are forced to allocate a greater share of their wallet to food and
energy. Finally, in the medium to long-term, there is significant risk from political unrest in emerging
markets (think food riots) and from governments trying to do too much to stamp out inflation (such as
the recently enacted laws in China where retailers must get approval from the government before they
can introduce price increases). Investors beware!

Hilltop Holdings Inc. (HTH-NYSE)

Hilltop Holdings (Disclosure: we own HTH) is a holding company whose main operating asset is NLASCO,
a P&C (property and casualty) insurance holding company. NLASCO is comprised of two insurance
subsidiaries, National Lloyds Insurance Company (NLIC) which primarily underwrites fire and
homeowners insurance to low-value dwellings, and American Summit Insurance Company (ASIC) which
underwrites insurance on manufactured homes.

Prior to entering the insurance business, Hilltop Holdings was formerly known as Affordable Residential
Communities Inc. and primarily engaged in the manufacture, sale and financing of manufactured homes.
In early 2007, Hilltop Holdings, under the direction of newly appoint Chairman Gerald Ford, sold off its
real estate business to hedge fund Farallon Capital Management for $1.8 BB (netting approximately
$550 MM in cash after taxes and debt) to focus on NLASCO, its newly acquired insurance business.
Hilltop also wanted to make further acquisitions with the proceeds of the sale.

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Before we discuss further on why we like Hilltop, we should really make a detour and talk about three
important and related topics:

1. Gerald Ford – Gerald J. Ford (not the former President of the United States, Gerald R. Ford), is a
successful billionaire from Texas who made his fortune from buying distressed banking assets,
fixing them up and selling them for substantial profits. He purchased his first bank in 1975 for
$1.2 MM and later sold it for an $80 MM profit. He is most famous for acquiring First National
Bank of San Francisco in 1994, merging it with Golden State Bancorp in 1998 and selling it to
Citigroup in 2002 for $5.3 BB, making Gerald Ford a billionaire in the process.
2. P&C Insurance – From studying the successes of Warren Buffett and Prem Watsa, we believe
we have a good understanding of the P&C insurance business. Broadly speaking, P&C insurance
companies can be separated into 2 groups: those that focus on market share and those that
focus on profitability. Insurers focusing on market share will aggressively pursue premium
volumes at the expense of underwriting standards, even in soft markets, when pricing is
generally inadequate. While in the short term, they may appear quite profitable (as rising
premium volumes can hide bad underwriting), in the long-run, they usually suffer heavy losses
from negative claims developments. Things to look for include combined ratios consistently
above 100% (meaning their policies are not priced adequately), a history of negative claims
developments (meaning when the claim was initially recorded, the insurer under-reserved for
the claim) and consistently high leverage (measured as premiums written / capital; 2 to 1 is
usually considered the limit, but this metric varies, especially for different kinds of insurance,
i.e., mortgage insurance typically have much lower premiums to capital because the risks are
longer-tailed and potentially larger).
On the other hand, insurers focused on profitability will typically see their premium volumes
stagnate or shrink in a soft market, as they would only underwrite profitable business. For these
insurers, the insurance business is really there to provide an investment float; if the insurer can
underwrite at breakeven or better, then the benefit of the investment portfolio accrue to the
shareholders. The power of this investment float could be quite significant, especially if the
investment portfolio is controlled by a good investor (think Fairfax and Berkshire Hathaway).
3. U.S. banking – Although the U.S. banking system is currently in tatters, with banks failing left
right and center, we have to take a longer term view and recognize that this phase is going to
pass. Banks have failed before in the past; most recently in the Savings & Loans Crisis of the
early 1990s (see Figure 7). In a normalized world (Reinhart & Rogoff’s research suggests the
average length of recovery from a debt-induced recession is 7 years and we are now in year 3),
banks should earn above 10% ROE (see Figures 7 and 8). At their peaks, banks can also trade
approximately 12 – 15x their earnings.

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18 1600
16 1400
14 1200
12
1000
10
800
8
600
6
4 400

2 200
0 0
1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Number of problem institutions Return on equity (%)

Figure 7: Bank Failures Have Happened In The Past. Source: FDIC, The Aspiring Analyst.

Figure 8: U.S. Banking ROA & ROE. Source: FDIC.

This brings us back to Hilltop Holding and the reasons why we like it. First, we like the $500 MM in net
cash HTH has on its balance sheet (more than $8.80 per share) and the Company’s stated goal to make
acquisitions or business combinations. Let us assume that HTH is able to acquire banking assets with a
book value of $500 MM. Further, assume when things normalize, these banking assets will be able to
earn 12% ROE, or $60 MM a year. Finally, assume that these earning will be valued at 12x by the market,

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or $720 MM. That would translate into $12.75 per HTH share in value. This is likely a lower-bound
scenario, as HTH is probably trying to acquire assets below book value and generate above normal
returns on those assets. Given the involvement of Gerald Ford (he has motivation to create shareholder
value since he owns 26% of HTH), what if he can buy good assets at 0.8x book value (there are currently
almost 200 public banks in the US trading at less than 0.8x book value), achieve a 15% ROE and gets a
premium multiple of 15x P/E? That would translate into banking assets worth $1.4 BB, or $25 per share
in 4 to 5 years time.

Certainly, there is upside potential. But we must caution investors that HTH has not yet made an
acquisition. In fact, Hilltop’s ‘shelf-charter’ from the U.S. Comptroller of Currency (the regulator)
obtained in 2008, was recently deemed to be outdated and hence HTH is in the process of updating and
re-filing a shelf-charter with no guarantee that the regulator will grant it. But I think the downside to
owning HTH at less than $10.00 per share is limited with $8.80 per share in net cash.

We also think the insurance business itself is undervalued. The current stock price implies that NLASCO
is worth approximately $1.00 - $1.20 per share, or $60 - $70 MM. This is an insurance company with
statutory capital (shareholder’s equity) of almost $120 MM, so the value ascribed to the insurer is 0.5 –
0.6x BV. Moreover, if you dig into the details, you would find that the insurance company has been
underwriting at a breakeven pace or better (97.6% combined ratio in 9 months to September and 96.8%
combined in 2010), with generally positive claims development in both NLIC and ASIC (look at claims
triangles in the 10-K). With premiums written to capital ratio of 1.1, the firm also has significant capacity
to write more business when P&C insurance markets eventually harden (when capital leaves the
industry and pricing improves). In a normalized cycle, insurance companies by themselves can trade up
to 1.5 – 1.75x BV, ($180 MM to $210 MM) or $3.20 to $3.70 per HTH share.

In summary, we like the fact that investors seem to fear the worst for HTH, ascribing book value to the
cash on hand and seriously discounting the value of the insurance business. We believe HTH has
significant asset value, with an undervalued insurance subsidiary worth up to $3.50 a share and the
potential to deploy its net cash into banking assets worth $12.75 to upwards of $20.00 a share. The
downside is that the insurance company remains profitable, but HTH experiences consolidated losses
from paying interest on its $130 MM in debt and fails to find a suitable acquisition. This would lead to
the stock being range-bound between $9.00 and $10.00. In our view, the risks are mostly to the upside,
for example, any progress on the acquisition front or improvements in insurance markets would boost
HTH’s valuation significantly.

Disclaimer: Our goal through this blog is to provide analysis and ideas that you, the reader, might find useful in forming your
own investment decisions and hopefully improve our analytical skills in the process. We are not soliciting for the management
of your investments nor seeking to provide financial advice. The Aspiring Analyst blog and letters will not take responsibility for
any investment losses incurred by readers through the trading of securities and strategies mentioned in this blog or its
accompanying letters. The views expressed in this blog and its accompanying letters reflect the author(s) personal views about
the subject company(ies) and its (their) securities. The author(s) certify that they have not been, and will not be receiving direct
or indirect compensation in exchange for expressing the specific recommendation(s). Readers are cautioned to seek financial
advice from qualified persons such as a Certified Financial Planner prior to taking any action in regards to the securities and
strategies mentioned in this blog or its accompanying letters.