Description

I am posting my two best ideas.  This is idea #1.

Atlas Financial Holdings, Inc. (NASDAQ: AFH)

Introduction

Atlas Financial Holdings, Inc. (“Atlas” or “AFH”) has many of the characteristics we look for in a great investment: hidden assets, competitors in trouble, earnings power that we believe is 50%+ above consensus estimates, misquoted share counts, latent hidden earnings power, spin-out and up-listing dynamics, a share overhang that’s almost gone, significant insider ownership, cyclical tailwinds, and an industry generally non-correlated to the macro environment.  This write-up is a follow-up to a post by mrsox977 in June 2012.  However, given that the re-listing from the TSX-V to the NASDAQ has now occurred, the issues at competitors have only recently been brought to light, and the timeliness of the story, we felt it was appropriate to post an update.

Shares in AFH US closed at $9.85 per share on Friday, a 1.6x multiple of stated book value as of the end of Q2 2013.  We believe “true” book value by year-end will be ~$8 per share, putting the company’s shares at 1.2x year-end 2013 book value.  By year-end 2015, we expect book value to be between $11-12 per share, at which time we think AFH will trade for >2x book value.  Our fair value assessment of approximately $25-30 per share represents potential 150%+ upside from the current share price over our two-year investment time horizon.

For the investment thesis, please skip to the bottom.  We begin with a background/history of the company.

Company Overview

Atlas’s core business is the underwriting of automobile insurance policies in the “light” commercial automobile sector, which includes taxis, limousines, and non-emergency para-transit (e.g., transporting a disabled senior from a nursing home to a scheduled doctor appointment).  The bulk of the business – more than 80% of written premiums – is in taxicabs and para-transit, with the taxi business the larger line of the two.

Atlas acts as holding company for two insurance subsidiaries: American Country Insurance Company (“American Country”) and American Service Insurance Company (“American Service”).  These subsidiaries effectively operate as Atlas’s two brands, with a unified back-office platform that centralizes business development, underwriting, and claims in Atlas’s headquarters.  AFH is licensed to write insurance in 47 US states and is currently active in 40, distributing product through a national network of independent retail agents.

In our view, Atlas’s business is a gem.  While writing insurance on taxicabs seems like a scary proposition, it is actually a wonderful sector to insure: taxis crash frequently (giving the insurer lots of data) and the accidents are generally low-dollar (fender-benders, etc.) – Atlas’s business is predictable and consistent, with low claims severity.  Atlas reinsures itself against larger accidents with Gen Re, a subsidiary of Berkshire Hathaway.

The industry structure is also favorable for Atlas.  We believe the total addressable market for taxis, limousines, and para-transit is just above $1B of premium across all underwriters, making it unattractive for many insurance companies to enter as it is simply too small to target.  Within this market, Atlas is the leading insurer for owner-operators and small fleets (1-10 vehicles).  While other insurers search for big-splash underwriting wins, Atlas grinds out higher margins with a service-oriented offering amid a more fragmented customer base.

Competitive Advantages

We believe Atlas has two significant competitive advantages:

1.  Underwriting.  For fleet operators, vehicle insurance is a legally-required cost of doing business but a minor/low-priority line-item.  As a result, carriers tend to procrastinate and wait until the last minute each year to renew their insurance agreements.  For the insurance agents acting as intermediary, speed in turning around quotes (to allow the carrier to remain in compliance against tight deadlines) is often of critical importance.  In most insurance sectors, including those Atlas participates in, a 2-4 week turnaround on quotes is typical.  Atlas’s underwriting operation – with the industry’s best data, most advanced modeling, and deepest experience (Atlas’s VP of Underwriting Bruce Giles has 31 years of experience; no member of his team has less than a decade) – can turn around quotes in 24 hours.  Based on conversations with agents, Atlas is frequently able to win business simply by being the only one capable of showing up.  Atlas’s experience and data also allows it to be flexible with clients seeking tailor-made insurance arrangements, making Atlas the go-to insurer for unusual structures.

2.  Claims.  Anyone who has dealt with a car insurance claim will appreciate how time-consuming the process can be to estimate damages, execute repairs, and repossess the vehicle.  For owners of taxicabs, limousines, or para-transit vehicles, a lengthy claims process is costly both in headaches and dollars: every day a vehicle is off the road is one fewer day the vehicle is earning revenues for its owner.  Atlas’s claims operation, led by VP of Claims Joe Shugrue (25 years P&C experience), averages 15 years of experience across dozens of claims agents and is structured to assess, repair, and return vehicles within 24 hours.  By keeping vehicles on the road, Atlas provides its clients with significant extra profits – a portion of which Atlas can recapture by charging premium rates – a win-win for Atlas and its clients.

Over the last decade, commercial auto has been among the best performers in P&C insurance with underwriting loss ratios ~1000bps better than the P&C average.  Atlas, operating in a niche with substantial competitive advantages, has 10-year underwriting loss ratios a stunning 1000bps better even than commercial auto.

The Atlas Story

Atlas’s roots can be traced back to 1925, when an early iteration of American Country first began selling insurance to taxis in the Chicago area.  American Country in its present form commenced operations in 1979, and American Service began four years later in 1983, both with a focus on non-standard automobile insurance.

The story gets interesting when Kingsway Financial Services, Inc. (“Kingsway” or “KFS”) enters the picture.  In 1997 KFS purchased American Service; five years later, in 2002, KFS purchased American Country.  Both acquisitions were part of a rapid growth strategy engineered by Kingsway CEO Bill Star and CFO Shaun Jackson to build out a multi-billion dollar insurance conglomerate prioritizing non-standard commercial auto insurance.

The strategy proved disastrous for Kingsway in a corporate history worthy of a business school case study.  Kingsway, formed in 1989 as a niche Canadian insurer, pursued a “growth at any cost” approach via an aggressive acquisition schedule and rapid underwriting growth (total written premium compounded at more than 60% per year from 1995 to 2003).  Alarmingly, Kingsway’s growth was driven in large part by Managing General Agents (“MGA’s”), to whom Kingsway outsourced underwriting, and by outsourcing claims – at the peak in 2005-06, nearly 60% of Kingsway’s claims were handled externally.  As anyone who lived through the subprime crisis can appreciate (think mortgage brokers at the peak of the housing bubble), outsourcing underwriting to MGA’s incentivized by volume rather than underwriting profit was a recipe for disaster.

2006 proved the top for Kingsway.  Huge losses, including hundreds of millions from its Lincoln General subsidiary that wrote trucking insurance, caused KFS’s stock price to slump more than 95% from a market cap of ~$1.3B to sub-$50M.  Kingsway CEO Bill Star resigned in late-2007, an activist investor group formed to oust management in 2008, and by late-2009 Shaun Jackson (who had taken over the reins as CEO) was out as well.

In mid-2008, Kingsway’s Board of Directors elevated Scott Wollney in connection with a reorganization aimed at saving the firm.  A decade earlier KFS had provided Scott with capital to launch a new subsidiary called Avalon Risk Management (“Avalon”); Scott successfully grew Avalon into a highly profitable business with more than a dozen offices and nearly $100M in revenue.  Recognizing his ability, KFS gave Scott the “keys to the kingdom” including the freedom to take employees from anywhere in the Kingsway universe to assist him.  Scott and his newly-formed insurance SWAT team moved rapidly to identify what to keep, what to sell, and what to shut.

Amongst the Kingsway wreckage, Scott came across a diamond in the rough – the assets that would eventually become a part of Atlas.  Starved of capital in the Kingsway collapse, Atlas’s premium volume had fallen from a peak of more than $120M in 2005 to less than $20M in 2010, putting the future of this business in doubt.

In early-2010, Kingsway spun out Atlas into a public Canadian-listed shell.  Scott and his team went with it, investing millions of dollars of personal capital into the business to take an ownership stake as well.  KFS was left with 75% ownership of the newly-listed company via restricted shares in addition to $18M in preferred shares.

Since 2010 the Atlas management team has taken all the right steps to re-foot the business.  Management has shed non-core assets (such as ownership of its headquarters building), re-established relationships with its agents, fixed its cost base, and begun to recapture business lost during the Kingsway debacle.  In addition, Atlas recently acquired Gateway Insurance Company (“Gateway”) – providing access to nine new markets including California.  Atlas now has an appropriate cost structure, is rapidly growing by recapturing attractive/high-margin business, and is once again profitable.

We view Atlas management – Scott Wollney, Bruce Giles, Joe Shugrue, CFO Paul Romano, and VP of Operations Leslie Dimaggio – as an elite team with an excellent track record and experience managing much larger insurance operations.  The team also has significant skin in the game (management owns >10% of outstanding shares).

In February 2013, Atlas re-listed to the NASDAQ exchange via a US IPO.  AFH has since pulled its Canadian listing given it has no operations in Canada.  KFS, which has a large debt rollover to meet in early-2014, sold down a significant portion of its stake to a 12% ownership position in the IPO and has recently filed to sell down its stake further to below 10% (so it will no longer be deemed an “affiliate” for regulatory purposes).  We believe KFS appreciates the value of its stake in Atlas and will likely stop selling once it goes below the 10% threshold.  The company’s shares are now freely traded in the US with a stable of high-quality institutional shareholders.

The Insurance Industry

Insurance companies make money in two ways: underwriting and float.  Underwriting measures the profitability of the insurance business proper; premiums charged to clients are offset by the costs of (i) claims, (ii) operational overhead, and (iii) new business acquisition (e.g., marketing or fees paid to brokers).  The standard industry measure for whether an insurance company is profitable in underwriting is the combined ratio.  A combined ratio above 100% indicates the insurance company loses money in its underwriting, and a combined ratio below 100% indicates the insurance company is profitable in its underwriting.  Most insurance companies have combined ratios close to 100%, indicating that they are roughly break-even in underwriting.

The other way insurance companies make money is on the float.  Insurers receive premium from clients up-front but only pay out claims over time; as a result, insurance companies have a large pile of cash “borrowed” from their customers at no cost that can be invested to generate returns.  This is the secret to Warren Buffett’s success at Berkshire Hathaway (“BRK”) – the float from BRK’s Gen Re, GEICO, and other insurance holdings provides him with a leveraged pool of low-cost capital to invest, so the insurance subsidiaries merely need to break-even in underwriting to generate value given Mr. Buffett’s considerable ability at investing the float.

The insurance business is cyclical.  The P&C insurance market has historically fluctuated between soft markets that tend to last 6-8 years and hard markets that are quicker, typically lasting only 2-4 years.  Soft markets are characterized by steadily declining premium rates as capital enters the industry seeking volume/growth over underwriting profit.  Eventually rates decline to an unsustainable level, and insurers experience losses as premiums prove insufficient to cover claims.  As weaker insurers exit, rates rise in a hard cycle that can prove extremely profitable for disciplined underwriters now able to charge higher rates given reduced competition.

We evaluate cyclical businesses like insurance on a through-the-cycle basis.  In our view, as Atlas returns to scale the company should be able to achieve an average through-the-cycle combined ratio of approximately 90%, broken down into a 66% underwriting loss ratio, a 9.5% overhead ratio, and a 14.5% acquisition cost ratio.  During soft markets we expect Atlas’s loss ratio to rise to ~70% (for a combined ratio in the low-mid 90’s) and during a hard cycle to fall to just below 60% (for a combined ratio in the low-mid 80’s).

An attractive part of the Atlas thesis is our belief that the P&C insurance market is now inflecting into a hard cycle.  The last hard cycle peaked in 2004, and since then the P&C industry has experienced 7-8 years of soft markets.  However, based on data from The Council of Insurance Agents and Brokers, industry surveys, and anecdotal evidence from market participants, we believe P&C insurance rates bottomed-out in late-2011 and have begun a choppy return to premium rate growth since then.

For Atlas’s business we believe there is strong evidence we are in the early stages of a hard cycle.  In addition to public commentary by Atlas management indicating market improvement, we can also point to several large-scale exits by competitors.  Mercury Insurance Group, previously the top underwriter of para-transit in California, has completely exited the space.  CNA, a multi-billion dollar insurer based in Chicago, left the taxi market earlier this year.  It also appears that Ullico Casualty Group (“Ullico”) is in the process of winding down its taxi operation.  Notably, both CNA and Ullico grew their taxi businesses primarily through the use of MGA’s.

Investment Thesis

Insurance companies tend to be valued on a multiple of book value.  During soft markets, insurers typically trade around 1x book value; during more-profitable hard markets, insurers can trade anywhere from 1.5x to 2.5x book.  Insurance companies that generate sustained through-the-cycle ROE’s in the neighborhood of 20% (as we believe Atlas can) tend to trade at >2.0x book value.

Hidden Book Value

As of the end of Q2 2013, AFH’s book value was $6.07 per share.  However, we believe this significantly understates Atlas’s true intrinsic book value as the company has taken a provision against net operating loss carry-forwards (“NOL’s”) that are available to offset future cash taxes.  Now that Atlas has inflected back to profitability, we believe Atlas’s auditors will force Atlas to remove the provision in accordance with US GAAP accounting rules.  Post the Section 382 triggering event in July 2013, the present value of the provision against the NOL’s on Atlas’s balance sheet is ~$10.2M against 9.4M fully diluted shares, or ~$1.08 per share of book value.  Our best estimate is that the provision will be removed in the company’s annual financial results for 2013 (i.e., Q4 2013).

In addition, Atlas agreed to repurchase KFS’s preferred shares at a 10% discount to par early in Q3 2013.  This represents ~$0.22 of incremental book value that will show up in Q3 2012 numbers.  Finally, AFH’s investment portfolio is conservatively managed and matches the duration of the company’s insurance liabilities (i.e., the company seeks to avoid interest rate risk and holds assets to maturity).  The marked-to-market unrealized losses on AFH’s fixed income portfolio that we expect to reverse as these generally short-term assets are held to maturity represent another ~$0.15 of book value.  Add in the approximately ~$0.50 of earnings we expect the company to generate by year-end, and we believe year-end 2013 book value will be in the neighborhood of $8 per share.

Competitors in Trouble

AFH’s largest competitor is Tower Group International, Ltd. (NASDAQ: TWGP).  TWGP represents ~20% of Atlas’s niche market, although this represents a smaller slice of TWGP’s overall business.  As of the beginning of August, TWGP traded at $22 per share with a market cap of $1.25B.  On August 7, however, TWGP announced it was delaying its Q2 2013 results and that it required an independent review of its loss reserves.  The stock plummeted 24%, and bled further in ensuing weeks.  On September 18, TWGP delayed its results again.  The stock fell another 27%.  TWGP shares have now lost nearly 60% of their value in two months and currently trade just above $9 per share.  AM Best has put TWGP on review for a possible downgrade to TWGP’s credit rating.

Another meaningful competitor to AFH is privately-held American Transit Insurance Company (“ATIC”) which largely operates in NYC, a market in which Atlas also competes.  ATIC represents ~7% market share in Atlas’s niche and is larger than Atlas.  Based on publicly-available regulatory filings, ATIC’s reserves / equity fell from $330M in Q2 2010 to $259M in Q2 2011 to $232M in Q2 2012 to $153M in Q2 2013.

While predicting the demise of a large competitor is difficult, should either TWGP or ATIC experience difficulties that compel them to reduce or shut underwriting in Atlas’s niche, we believe Atlas could reap windfall profits as the gradually-hardening market goes vertical.

Consensus Estimates

Consensus Bloomberg estimates for AFH’s earnings are $0.15 in Q3 2013, $0.95 for 2014, and $1.11 for 2015.  We believe these are materially too low.

There are several reasons why we believe consensus estimates are off.  First, we note the confusion caused by AFH’s share count last quarter when, per US GAAP accounting, the redeemed preferred shares were included in the share count for the quarter, inflating the diluted shares outstanding to 10.97M.  This will reverse going forward, and the appropriate fully-diluted share count to use is 9.4M.  Second, consensus estimates appear to assume the seasonality Atlas used to have when it was focused on only a couple of geographies; now that Atlas is widely diversified across 40 states, we believe this seasonality will essentially no longer exist.

Based on $1.5M of net income and a fully diluted share count of 9.4M shares, we believe AFH earned $0.16 per share in Q2 2013.  Consensus appears to expect earnings to drop next quarter.  Our view is the opposite.  We believe the company will continue to rapidly grow its underwriting and profitability on a largely fixed cost base into a hardening market, and that organic growth will account for EPS growth of ~$0.03-0.04 per share QoQ.  In addition, Atlas will save $0.01 from a reduction in preferred dividends and $0.02 per share from the elimination of one-time workers comp and integration costs associated with the Gateway acquisition.  All-in, we believe Atlas will earn approximately $0.22-0.23 per share in Q3 2013 vs. consensus at $0.15, or ~50% above consensus.

Importantly, we believe Atlas is in roughly the third inning of its growth story and that the company can continue to rapidly grow premiums into a hardening market for the next 6-8 quarters.  We also note that Atlas is currently booking its earned premium at an underwriting loss level of ~65%.  However, we believe Atlas is writing new business at a level some 700-800bps below that.  That delta represents incremental earnings of ~$0.08 per share per quarter, which we expect will start to show up in the numbers at the beginning of 2014.  We think EPS will be between $1.25 and $1.50 in 2014 (against consensus of $0.95), and near $2.00 per share in 2015 (against consensus of $1.11).

How This Plays Out: Catalysts

We note a series of catalysts over coming quarters in AFH shares:

• Q3 2013 Earnings – we expect earnings to be substantially above consensus estimates, as outlined above.
• Q4 2013 Earnings – we expect the provision against NOL’s to be removed from AFH’s financial statements, unmasking AFH’s true book value.
• Q1 2014 Earnings – we expect AFH to begin to recognize earned premium more in-line with the loss levels at which AFH is currently writing its business.

Additional catalysts could include (i) further issues at TWGP or ATIC leading to a hard market supercycle, (ii) AM Best upgrading its rating on AFH, (iii) the removal of the KFS overhang and an increase in the company’s float, and (iv) additional accretive acquisitions.

Risks

As with any investment, there are risks to investing in Atlas shares, including the potential impact of inflation on book value, being wrong on the cycle, and execution risk.  Should a major competitor decide to enter Atlas’s niche market, there could prove to be a temporary or sustained disruption to Atlas’s earnings power.  In addition, Atlas has made clear it intends to serve as an acquisition platform in the future, and the risk exists that Atlas will execute acquisitions that do not add or that reduce intrinsic value.  Finally, the liquidity of AFH shares, though improving, remains relatively low as shares tend to trade in blocks rather than continually over the course of the trading day.

Disclaimer

The author of this posting and related persons or entities (“Author”) currently holds a long position in this security.  Author may buy additional shares, or sell some or all of Author’s shares, at any time.  Author has no obligation to inform anyone of any changes to Author’s view of AFH US.  Please consult your financial, legal, and/or tax advisors before making any investment decisions.  While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note.  The reader agrees not to invest based on this note, and to perform his or her own due diligence and research before taking a position in AFH US.  READER AGREES TO HOLD AUTHOR HARMLESS AND HEREBY WAIVES ANY CAUSES OF ACTION AGAINST AUTHOR RELATED TO THE NOTE ABOVE.  As with all investments, caveat emptor.

Catalyst