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WSC AT A GLANCE

P/E ► 29.6 HIGH EV/EBITDA ► 24.7 VERY HIGH ROA ► 2.4% AVG ROE ► 3.1% AVG Debt to Equity ► 0.313 VERY LOW Interest Coverage Ratio ► 67.1 VERY HIGH

 

 

 

 

 

 

Wesco Financial Corporation (AMEX:WSC) is a multi-faceted company that has operations in three main areas: the property and casualty insurance business, the furniture rental business, and the steel industry. Moreover, since 1973 it has been controlled by Berkshire Hathaway (BRK) who, through one of its many subsidiaries, owns an 80.1% equity stake in Wesco.^[1]

In the second quarter of 2008, Wesco, like many other companies, began to feel the impact of the financial crisis, posting a 22% year-on-year drop in net income. Wesco blames most of this loss on reduced demand for its insurance services, which are aimed primarily at a commercial property industry that has seen double digit declines in value since the beginning of 2008.^[2] Moreover, its insurance operating expenses have increased more than 5% between 2007 and 2008 which has contributed to a lower overall profit margin.^[3]

In 2008, Wesco expanded its furniture rental segment by purchasing Roomservice Group located in the United Kingdom as well as a division of Aaron Rents located in the United States.^[4] These acquisitions come at a time when the rent-to-own industry, as a whole, is experiencing mixed results as sales to consumers grow due to the lack of traditional bank financing and credit that would have ordinarily allowed customers to purchase expensive products upfront while sales to businesses decline due to lower economic growth.^[5] The economic slowdown , however, will have a negative impact on Wesco Financial's steel business as manufacturers reduce production in order to cope with reduced consumer demand.^[6]

One aspect of Wesco Financial that has drawn attention from shareholders is the extent to which management decisions are influenced by Warren Buffet, who effectively controls Wesco Financial through his 28.1% ownership of shares in Berkshire Hathaway. In an interview with the CEO of Wesco, Charles Munger (a close friend of Buffet's), in May 2007, it was revealed that the strength of his influence causes many Berkshire subsidiaries, including Wesco Financial, to voluntarily check in with Buffet before engaging in any major transactions.^[7] The fundamental issue that such an ownership structure brings up is the potential for a single individual, Warren Buffet, to override minority shareholder interests.

Business Overview

The three divisions of Wesco financial are formally designated as the Insurance, Furniture Rental, and Industrial segments. Operations within each segment are carried out by distinctly named subsidiaries that are directly managed by Wesco Financial.

The furniture rental segment is the highest revenue grossing segment within Wesco Financial.

The Insurance segment is responsible for much of Wesco's income and has seen slight declines between in 2007 as a result of the financial crisis

Insurance Segment (% Revenue: 11% , % Income: 77%)

Wesco engages in both primary insurance as well as reinsurance through two subsidiaries called Wesco-Financial Insurance Company and The Kansas Bankers Surety Company. Unlike primary insurance, reinsurance is a way for WSC to provide insurance to other insurance companies. In this process these other insurance companies are able to take on greater risks then they would be able to do without reinsurance contracts.^[8]

The insurance segment of Wesco Financial represents the smallest proportion of revenue and yet the largest amount of net income. This discrepancy can be primarily explained by two factors. Wesco financial has been able to keep overhead expenses constant and between 2006 and 2007 even managed to reduce these expenses by 6%. More importantly, though, is the investment income from the insurance segment which accounted for more than 90% of the total income in the insurance division.^[9] The investment portfolio of Wesco Financial is comprised of primarily of traditional equity and debt holdings with investment income coming largely from dividends rather than capital gains.^[9]

Furniture Rental Segment (77%, 22.1%)

Wesco operates its furniture rental segment through a subsidiary called CORT Business Services Corporation which offers a large selection of desks and other assorted office furniture to customers who can either lease or rent-to-own the products. This segment is extremely sensitive to economic conditions since many of its customers are other businesses and in 2007 saw net income decrease by .6% following an increase of nearly 5% in year 2006 as a result of the slowdown in the US economy. For the second quarter of 2008, rental revenues continued to fall declining 2.1%.^[9] These declines are excluding trade shows and convention contracts which represent only one time sales and are not viewed as consistent and reliable clientele by Wesco. The falling revenue is mainly associated with decreased customer demand that can be tied to uncertainty regarding future economic conditions.

Additionally, this segment saw service fees rise more than 30% in the second quarter of 2008 as compared to 2007, even though revenues during this same period increased by only 1%.^[10] The most significant expense, though, that Wesco faces are its selling, general, and administrative expenses which accounted for nearly 75% of this segment's costs in fiscal 2007 and have also increased at a faster rate than revenue between 2006 and 2008.^[9]

Industrial Segment (12%, .9%)

The Industrial Segment for WSC is operated through a subsidiary called Precision Steel that has plants in both Chicago, IL and Charlotte, NC. Revenues are generated through the purchase of raw metals that are then cut to a customer's specifications and sold. The market share that is controlled by Precision steel is relatively small; it manufactured only 20 thousand tons of steel in 2007, in total market of more than 60 million tons - only .03% of the total steel market. However, unlike its larger competitors WSC specializes in producing niche steel products for a small number of customers. In 2006, one customer accounted for more than 50% of the revenue increase.^[9] In the second quarter of 2008, Precision Steel generated only $600,000 in income for the firm making it the smallest segment in WSC by profit.^[10]

Key Trends and Forces

The 2008 Financial Crisis and ensuing recession will affect all segments of WSC

All three segments of WSC are positively correlated with the economic cycle.

• Insurance: During economic upturns, as businesses buy capital and expand operations, they seek to purchase the exact type of insurance offered by WSC.^[11] During downturns ,though, not only will WSC have a more difficult time getting new customers, many existing customers will reduce their insurance coverage in order to lower their premium payments, which will negatively affect Wesco's revenue.Traditionally, WSC has also offered insurance of bank deposits above the FDIC insurance level of $100K. However, the increase in bank failures between 2007 and 2008 has caused WSC to lose $5 million on these insurance policies and forced the company to eliminate this offering in order to maintain profitability.^[10] Additionally, the 2008 Financial Crisis has caused WSC's investment income, which is primarily composed of investments in common equity, to decline 18% during 2008.^[10]
• Furniture Rental: The same logic holds for this segment - during times of economic growth, businesses seek to acquire the necessary equipment for their offices. However, during periods of slower growth, WSC will have to deal not only with diminishing demand but also with the increasing costs of holding furniture as inventory in warehouses.^[12] The acquisition of a segment of Aaron Rents (RNT) during 2008 will help to negate some of the decreases in income as Wesco moves towards providing furniture rentals for the everyday consumer.
• Industrial: This segment, like the broader manufacturing industry, is intricately tied to consumer demand, which has historically diminished during economic downturns. These fluctuations are most strongly felt in the specialty stainless steel products produced by WSC.^[13] During 2007, sales of these products declined more than 14%.^[9]

Economies of scale amongst competitors could hurt profits in the Industrial Segment

The steel industry, while made up of many firms, is dominated by two: Rio Tinto (RTP) and ArcelorMittal (MT) which together make up almost 50% of the market.^[14] The large scale of production that these two firms are capable of allows them to have profit margins of 25% and 11%, respectively, compared to WSC's profit margin of only 3%.^[15] One of the main benefits from a larger operation is the higher return that can be achieved on the expensive capital outlays that are required in order to mine, manufacture, and/or mold the raw materials into useable products that can be sold to distributors and wholesalers. However, both types of manufacturers will see reduced profits as a result of declining economic conditions. For generic bulk manufacturers such as Rio Tinto (RTP), falling profits result from falling market prices of steel as demand for raw materials decreases.^[16] On the other hand, specialty steel makers such as WSC, are heavily dependent on a limited number of customers which may be responsible for a large proportion of the profits. In 2006, more than 50% of Wesco's net income in the industrial segment was related to sales to just one customer and in economic downturns these customers will either reduce their order amounts or even shift their purchases to plants located overseas.^[9]

The potential influence of Warren Buffett on dictating the actions of WSC is significant

The 2008 CEO of Wesco Financial, Charles Munger, has been close friends with Warren Buffet for many years. The two have often appeared in public, and many publications have suggested that the two often discuss the details of the large businesses that they own and operate.^[17] More important, however, is the fact that Munger has publicly revealed that he has sought Buffet's advice regarding investment and capital allocation decisions within Wesco.^[18] While there are no perverse incentives for Warren Buffet to make decisions that harm WSC's shareholders, the potential for one individual, who is proximal to a company's daily operations, to affect share price can make them more volatile, as well as override the interests of any smaller shareholders.

Competitive Analysis

The unique organizational structure of WSC in terms of the types of business that it is engaged in makes it difficult to find direct competitors. However, there is one other company, Blackstone Group (BX) that owns a diversified array of companies and competes against WSC both in terms of the amount of income that is brought in and the level of returns that these companies can provide for shareholders. Using the performance metrics outlined above it is also possible to compare the individual segments of WSC with other companies that offer similar products.

Competitive Analysis By Segment

Wesco Financial performs significantly better than other insurance companies involved in the property and casualty insurance business when the combined ratio is used as a metric of comparison. However, due to the complexity of the different insurance policies offered by each company as well as differences in the risk of their insurance portfolio it is difficult to use the combined ratio metric alone to definitively rank performance.

Wesco's Furniture Segment performs relatively poorly compared to the broader industry where some firms such as Ryder System (R) have been been able to keep costs to only 42% of revenues. The economies of scale associated with furniture rental may help to explain why firms that are larger are able to keep costs at a lower level. Additionally, all of the other firms listed below have considerable segments of their business dedicated towards servicing individual consumers through retail stores which can help to increase revenues.

The profitability of Wesco Financial's Steel Segment is comparable to other firms in the specialty steel industry. The differences are primarily due to the different clientele each firm caters to with some firms, such as Mechel Steel Group OAO (MTL), producing relatively less "finished" specialty products as such slabs and tubes while other firms, such as Wesco, produce complex steel alloys that require greater costs.^[28]

References

1. ↑ Wesco Financial Company Homepage: Links to Affliated Companys
2. ↑ Boston Globe 12/23/08: "US Developers Seek Aid from Government"
3. ↑ Wesco Financial 2008 Q1 10Q: Page 5
4. ↑ The Atlanta Journal-Constituion 9/15/2008: "Warren Buffet Company buys Aaron Rents Division"
5. ↑ Atlantic City Press 12/25/08: "Rent-to-own business is booming"
6. ↑ Time Magazine 10/10/08: "Is Cheaper Oil a Good Thing?"
7. ↑ Notes from Wesco Annual Shareholders Meeting: page 8
8. ↑ Insurance Journal 7/4/2005: "What is Finite Risk Reinsurance? A Definitive Explanation"
9. ↑ ^{9.0 9.1 9.2 9.3 9.4 9.5 9.6} Wesco Financial WSC Report 10k 2007
10. ↑ ^{10.0 10.1 10.2 10.3} WSC 2008 Q3 10-Q
11. ↑ The Guardian UK 10/17/08: "Insurance Company investors push panic button"
12. ↑ Business Review Western Michigan 6/11/2008: "Economist: slow growth for commercial development
13. ↑ Reuters 12/11/08: "Production Cuts by Major Global Steel Firms"
14. ↑ Yahoo Finance: Steel Industry Browser
15. ↑ Rio Tinto Income 2007 Income Statement
16. ↑ Associated Press 12/25/08: "JFE Steel to shut blast furnace as demand falls"
17. ↑ Smart Money Magazine 9/2/2008: "Warren Buffet's Best Man"
18. ↑ The Charleston Post and Courier 6/1/08: "Warren Buffet's $2 billion right-hand man"
19. ↑ Yahoo Finance: WSC Competitive Comparison
20. ↑ TRV 2007 10K: Page 68
21. ↑ ACE 2007 10K: Page 33
22. ↑ CB 2007 10k: Page 26
23. ↑ ALL 2007 10k: Page 31
24. ↑ RNT 2007 10K: Page 23
25. ↑ UHAL 2007 10K: Page 25
26. ↑ ELRC 2007 10K: Exhibit 13 Page 18
27. ↑ Ryder System 2007 10K: Page 23
28. ↑ Precision Steel Warehouse Inc. Products
29. ↑ MTL 2007 Annual Report
30. ↑ AKS 2007 10K: Page 17
31. ↑ WOR 2007 10K: Page 19
32. ↑ CRS 2007 10K: Page 19