Description

Back out the $8/share in net cash and American Physicians Service Group stock is cheap at a trailing P/E of 10x.  Better yet, it’s set to merge with a related company in a highly EPS accretive transaction, which makes the P/E drop to 5x.

For further background, you can check out a timely previous post from another member two years ago.  I’ll first discuss AMPH as it looks today, and then talk about the implications of the pending merger.

THE COMPANY TODAY

AMPH is an extraordinarily profitable $49 million market cap company based in Austin, Texas.  It has two businesses, APS Insurance and APS Financial, both with high ROEs and great cash flow: if you back out the cash and securities from shareholders equity, AMPH has been earning over 100% ROEs for the past few years.  Historically, the two segments have each accounted for roughly half of AMPH’s earnings, but with the hard market in insurance the last couple of years, profits have been tilted heavily towards insurance.

APS Insurance is the manager of Texas’s 3^rd largest medical malpractice insurer, American Physicians Insurance Exchange, or APIE.  Note that APS is not an actual insurance company itself, it’s just the hired manager.  In legally specific terms, APIE is a reciprocal insurance exchange and APS is its attorney-in-fact, hired by APIE’s Board of Directors to manage the firm.  The crucial point for now is that APS Insurance takes on no direct underwriting risk; it simply receives a management fee off the top and also receives a profit-sharing fee.  This arrangement will disappear with the pending merger, so I won’t dwell on the details, but suffice it to say that this is an astonishingly profitable arrangement for APS Insurance, since not only does it have no risk to its capital, it has virtually no invested capital at all!  In 2005, APS Insurance reported $15.5 million in revenues and $5.3 mil in segment operating income.  The profit margins are even better than they look, since the revenues include over $4 million in pass-through commissions.

APS Financial is a small, fixed-income focused securities brokerage firm.  AMPH entered this business in the early 1980s, hoping to cross-sell investment services to its doctor client base, but that strategy never panned out, and APS Financial eventually shifted its attention to institutional clients, which remain its bread and butter today.  It’s been quite profitable, with ROEs I’ve been told in the 20-25% range historically (the company doesn’t provide enough information for an outsider to confirm this).  However, the vast majority of its revenues are from bond trading commissions, which have been somewhat weak the past year or so.  With the environment only getting tougher, they’ve begun diversifying into asset management and investment banking, though both are still quite small.  In 2005, APS Financial reported $18.5 million in revenues and $2.3 million in segment operating income.

The quick financial summary using September 30, 2006, figures is this.  AMPH has $23.6 million of cash and securities ($8.15/share on 2.9 million shares outstanding) and no debt.  It earned $0.96/share in the trailing 12 months excluding investment gains and interest income.  So backing out the cash from the today’s $17.50 stock price, you get a trailing P/E of 9.7x.  This is cheap, but the proposed merger discussed next makes the multiple look even cheaper.

THE PROPOSED MERGER

AMPH is proposing to acquire APIE, the medmal insurer that it manages, for about $39 million, mostly in AMPH stock.  The purchase price is 0.9x surplus.

The deal’s strategic rationale makes sense.  AMPH has excess capital, while APIE is capital-constrained.  AMPH’s CEO Ken Shifrin is a smart and aggressive entrepreneur, and is reluctant to re-invest the excess cash in businesses he doesn’t know as well.  APIE, meanwhile, because of its unusual reciprocal exchange structure, can’t raise capital easily.  This combination solves both problems in one stroke.  There is absolutely no integration risk.  Not a single thing will change operationally after the deal closes – the same people will run it in the same way it’s been run before.  All the deal does is collapse the reciprocal/attorney-in-fact dual firm structure.

The highlight of the deal, though, is that the profit accretion is enormous, both near-term and longer term.  AMPH will report somewhere around $1/share in earnings for the full year 2006.  Pro forma of the APIE merger, that will be more like $3.30/share of earnings!  Below are earnings before and pro forma the merger, excluding one-time gains.

                                                2005                2006e              2007e

            Net Income                   $3.5 mil            $2.7 mil            $2.4 mil

            Shares Outst.                  2.9 mil              2.9 mil              2.9 mil

The big pro forma accretion reflects the benefit of owning all of APIE’s profits, rather than just receiving a portion of it as a profit-sharing fee.  Under the current agreement, AMPH receives 50% of APIE’s net income, but it’s capped as a percentage of APIE’s gross earned premiums.  So in highly profitable years like 2005, 2006, and most likely 2007, AMPH caps out on the profit-sharing fee and misses out on the upside.  The total annual revenue AMPH has received from APIE has been flat at $11 million since 2004, even though APIE’s net income has tripled in that span, because APIE’s earned premium revenue has been flat.  In effect, AMPH has left multiple dollars of EPS on the table.  This deal should double AMPH’s normalized nearing power over a full cycle from $0.80-1.00/share to $1.50-2.00/share.

There is one noteworthy negative to the deal for AMPH shareholders: AMPH will own an actual insurance company, so it’ll be exposed to all the capital needs and claims liabilities like any other insurer, nullifying its superb financial profile as an attorney-in-fact.  So all else equal, one should pay a lot lower multiple for a dollar of earnings from the new AMPH than for a dollar of earnings from the old AMPH.  However, this significant negative is offset, at least partially if not wholly, by three considerations:  1) APIE will have more flexibility and strategic opportunities to pursue growth, 2) the Texas medmal industry is structurally more favorable than in the past and AMPH will now reap the full benefits, and 3) the aforementioned financial accretion to AMPH shareholders.

The first two points are qualitative, but very important points.  APIE, because of the reciprocal structure, can't raise capital easily, restricting its growth opportunities.  For example, after an industry shakeout a few years ago in Texas medmal, pricing turned very favorable; while APIE benefited enormously, it couldn’t write as much business as it wanted to because it was capital-constrained.  As an incorporated subsidiary of AMPH, the insurance company will now be able to transfer capital in and out a lot easier.  The structural industry change is that Texas passed tort reform in 2003, and partly as a result, losses have dwindled and pricing began turning south about two years ago.  The very long-term impact of tort reform is still unknown, but it should mean that this downslope should be more benign than previous downturns, and the current overall cycle should be much more profitable than past cycles.  If AMPH owns APIE, its profits will no longer be capped by the profit-sharing formula, and AMPH should capture the incremental upside for itself.

VALUATION

The shareholder vote on the merger is on March 22, and AMPH will release 4Q earnings right after the vote date.  The stock popped on the merger announcement and has retained its gains, but I still don’t think that investors fully understand the accretion to current and long term earnings.  As the merged company reports its earnings, the stepped-up earning power should become clear.

After the merger, AMPH will have about $5/share in cash and still no debt.  It will have earned about $3.30 in 2006, or $2.40/share excluding favorable reserve development.  So the pro forma trailing P/E, backing out the cash and favorable reserve development is 5.4x.  Given current trends in medmal in Texas, I expect 2007 to be another good year, though certainly not as good as 2006.  AMPH could earn around $2/share pro forma in 2007, giving it a forward P/E of 6.5x.  Even assuming that we are on the downslope part of the cycle, this is too cheap.  Normalized earning power is probably around $1.50-2.00/share, so AMPH is trading at around 7-8x normalized EPS.  Just getting to a 10x P/E on normalized earnings would make this a $20-25 stock, and a more reasonable multiple would be 12x, or $23-29/share.

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