Description

ACAP is a medical malpractice insurance company that trades for 64% of tangible book value and 5.0x next year’s fully taxed EPS. After years of false hopes and bad execution ACAP has finally turned the corner. It was written up a couple times on VIC before, but both write-ups proved too early and ACAP’s business and management continued to prove worse than everyone thought. However, I’m confident now is the perfect investment point for ACAP.

ACAP is headquartered in Michigan, with operations in 13 states. They have recently exited all businesses other than medical professional liability.

INDUSTRY

I wrote up FPIC (another public med/mal company) a few months ago, so I know the industry well, and I’ve taken much of what I wrote from there. They are both benefiting from the same excellent industry conditions.

As most people know, there is a Med/Mal crisis going on in the US. Med/Mal insurance companies lost a fortune on the policies they wrote in the last 4 years. Dozen of companies have pulled out of the business, including the largest writer in the country St. Paul, and the rest have pulled back in many areas or were put out of business by losses.

The response has been a public outcry and several states introducing tort reform. And the insurers have raised rates anywhere from 100% to 400% in almost every single state in the US over the past 3 years.

This sort of cycle seems to happen every 10-15 years in Med/Mal. And every time it does, the players left standing end up making a fortune in the hard part of the cycle.

This is where we are today. Based on a detailed review of ACAP’s reserves, I believe the rates in place today will prove to be highly profitable.


ISSUES


ACAP de-mutualized in December of 2000 and then one year later had to strengthen reserves. This was the beginning of three years of slow torture as ACAP made mistake after mistake. The CEO and CFO were inept boobs who probably should have been running a lemonade stand, not a med/mal insurance company.

-- ACAP raised rates and changed their underwriting too slowly when it became clear losses were rising.
-- They exited loss states too slowly.
-- They denied the problems they were having by only adjusting loss reserves slowly over a long torturous period instead of all at once.
-- They tried to move into workers comp and out of med/mal as problems became obvious, only to do the exact opposite a few months later.
-- They tried to make a bad acquisition of a workers comp business, but cancelled it after shareholder protests.
-- They repurchased stock to appease nazi hedge fund managers who think stock buy-backs are always the best thing to do, only to run into capital problems.
-- They’ve lost a fortune on policies written in the years 1999-2002.
-- They expanded into states they knew nothing about at the worst part of the cycle. Now they’ve lost a fortune trying to exit those states, especially Florida, their most disastrous state.


WHAT’S RIGHT


At this point, all bad news is most likely in the past. Fortunately, ACAP was over capitalized when it began its death spiral, so it has survived the ordeal basically intact. Now:

1) ACAP has raised rates about 90% in all of its states in the last 3 years.
2) ACAP is raising rates another 24% this year, even though loss costs are only going up 5-10%.
3) ACAP has re-written it’s entire book of business, dramatically lowering limits and dropping unprofitable policies.
4) ACAP has exited unprofitable states, notably Florida.
5) ACAP took a huge reserve addition in Q3. So reserves are most likely finally solid.
6) The CEO, Bill Cheesehead, finally quit. Kevin Clinton, a med/mal veteran was promoted to CEO. (the idiot CFO, Freund, still works there)
7) ACAP has turned profitable again!

Nobody seemed to notice, but in the December quarter they made a lot of money in Med Mal. The results were skewed by exit costs from Workers Comp and other reorg items, but their on-going business, med/mal, did great. Claim counts have trended way down from a year ago, and premium prices are still going up 20% per year. The reorg items will be smaller and smaller as the year goes on, and should disappear by year-end.


FINANCIALS


Excluding the businesses ACAP is exiting, they made $0.44/share (assuming a 38% tax rate) in Q4 in their base business.

Reported book value is artificially low since ACAP was forced by accounting rules to write-off their entire tax asset, due to three years of losses. However, this just means they won’t be recording tax expense this year, despite being profitable. They will likely “un-reserve” the tax asset at year end.

Stock Price: $19.00
Shares Out: 8.5mm
Market Cap: $161mm

Q4 run rate earnings: $1.76/share
Book Value: $23.87/share
Tangible Book: $23.69/share

Tangible Book including tax asset: $29.57/share


Run-rate P/E: 10.8x

P/Tang Book including tax asset: 0.64x
P/Reported Tang Book: 0.8x


OUTLOOK


After a detailed review of ACAP’s reserves, I believe their reserves for previous years are adequate, given the recent reserve additions. I also believe that they are being overly conservative on the business they are booking this year. Given their miserable past, it is obviously wise to start building a cushion into their reserves now that pricing is so good. With rates going up more than twice as fast as loss costs, much of the rate increases should be falling straight to the bottom line. However, this has yet to happen, since it is a long tailed business and the new management is wise to be conservative for now.

As they continue to earn in the 30% rate increase they took last year and the 24% rate increase they are taking this year, loss ratios should come down dramatically.

Every dollar of rate increase in excess of loss increases should fall straight to the bottom line. While loss trends have been going up an average 7% per year, the 30% price increase they took last year and the 24% this year dwarf the loss trends. So there is obviously a lot of cushion in their current reserving.

Every 1 point improvement in the loss rate translates into $0.13/share in EPS.

ACAP, like every other insurer, is also being negatively impacted by low interest rates. If their average yield goes up by only 1%, this adds $0.61/share to EPS.


PROJECTIONS:


For my projections, I exclude the businesses they are exiting. While there will probably be some noise around them, they are irrelevant and unlikely to cost any meaningful amount of money at this point.

I believe ACAP will show a dramatic improvement in loss ratios this year, but for conservatism my model assumes ACAP basically shows NO improvement over the Q4 run-rate, and instead builds reserves. I assume an 85% loss ratio and per the company’s guidance, underwriting expenses should come down a little.

2004E Reported EPS: $4.00
2004E Fully Taxed EPS: $2.50

2005E Reported EPS: $6.00
2005E Fully Taxed EPS: $3.75

P/E 2004E Reported EPS: 4.8x
P/E 2004E Fully Taxed EPS: 7.6x

P/E 2005E Reported EPS: 3.2x
P/E 2005E Fully Taxed EPS: 5.0x

If interest rates go up 100 bp = +$0.61/share
If current loss ratio assumption proves 5 points redundant = $0.65


DOWNSIDE


I do not believe there is any real downside at this level. I have analyzed their reserves thoroughly and believe the risk to their reserve position, especially after their large reserve addition, is limited – though there is always risk of adverse development in their reserves. In addition, the legal environment continues to become more favorable as states institute tort reform laws, and Congress considers national tort reform laws.

Downside is limited:

1) Stock is currently significantly below tangible book value, despite recent reserve additions, and despite a fantastic business outlook.

2) ACAP is poised to generate about a 16% fully taxed ROE.

3) Stock is currently trading at only 10x run-rate earnings, and earnings are set to more than double in the next two years.

4) Stock is trading at 7.8x this year's fully-taxed estimated earnings.

5) Current conditions in the Med/Mal business couldn’t be any better.

6) Pricing is fantastic and still going up.

7) Competition has decreased in almost every one of their markets.

8) Interest rates will inevitably go up and boost investment income.

9) The wind is at their back in terms of tort reform and other potential legislation.


TARGET


I believe this will trade at least like a normal insurance company, at 1.5x book and around 12x-15x forward earnings (below historical peaks in hard insurance markets, and below my target for FPIC due to not being as well run, having a lower ROE and not growing as fast).

Book value at the end of this year will be about $30/share, including the deferred tax asset, which should be “put back on” the balance sheet at the end of the year.

My intermediate target: $45.

At $45, ACAP will be at about 1.5x book, and about 12x next year’s fully taxed earnings of $3.75.

Catalyst

CATALYST:

1) The obviously cheap valuation
2) When people finally accept that Med/mal, and ACAP particularly, have turned the corner, they will stop applying a distressed multiple to this business. It already has just started with FPIC, now it is ACAP’s turn.
3) If FPIC, as I expect, reports a good Q4 next week, this should give the sector a boost. It will confirm that business really is improving.
4) Earnings acceleration, which is just starting. This will also become more obvious as the noise from exited businesses goes away.
5) If ACAP becomes profitable this year as I expect, they will be able to put their tax asset back on the books. This will dramatically increase book value, and would make the cheap valuation more obvious.
6) AM Best will eventually raise ACAP’s rating back to where it was before the recent reserve adjustments.