| 2008 | 2009 | ||||||
| Price: | 16.50 | EPS | |||||
| Shares Out. (in M): | 0 | P/E | |||||
| Market Cap (in $M): | 248 | P/FCF | |||||
| Net Debt (in $M): | 0 | EBIT | 0 | 0 | |||
| TEV (in $M): | 0 | TEV/EBIT | |||||
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Don’t bother looking at this one if anything “financial” sends shivers done your spine. However, if you are a brave soul who doesn’t mind buying an ultra-conservative, overcapitalized Midwestern P&C insurer at a significant discount to book value and a mid-single digit multiple of normalized earnings, enter Baldwin & Lyons, Inc.
Baldwin & Lyons Inc. (BWINB) is an
- BWINB’s stellar underwriting track record with a long-term historical combined ratio of 95%. In addition, the company is highly conservative in its reserving, as historically BWINB has experienced significant favorable reserve developments, equal to 10-20% of the original loss estimates.
- Excellent financial condition, as BWINB subsidiaries boast an A+ (“Superior”) financial strength rating from A. M. Best. The company has excess cash on its balance sheet equal to 20% of its market cap, boasts a premium-to-surplus ratio of under 0.4, and could pay a dividend in excess of the current market cap without terminally impairing the business and taking on debt.
- Outstanding management team, which has significantly increased the value of the business over time through diligent underwriting and opportunistic approach to growth, while returning excess funds to shareholders through generous dividends and share repurchases.
- Ample long-term growth potential, as evidenced by a very large size of BWINB’s end markets, which are populated with insurers who pursue inefficient business strategies and who are saddled with subpar financials.
- Dirt-cheap valuation, as BWINB stock is selling for approximately 6X CFY normalized economic earnings and for approximately 65% of tangible book value. In addition, the stock sports a 6% dividend yield.
If this is enough to peek your interest please read on further for a more detailed overview.
THE BUSINESS AND ITS COMPETITIVE ADVANTAGES
Property & Casualty insurance is essentially a commodity business, in which to develop and sustain any sort of competitive advantage is very hard. The poor economics of the industry are evidenced by the fact that over the long-term an average P&C insurer generates a combined ratio of well in excess of 100% and a cost of float that exceeds its cost of funding. However, despite the dreadful economics of the industry, there are exceptions to the rule, and BWINB is one the few of them. While most insurers are organizationally set up to write for market share (which generally results in poor underwriting profitabilty), this is the exact opposite of the way BWINB has been running its business for the past several decades. In contrast to the majority of its rivals, the company’s management team understands that in a commodity business the size of the market share does not affect your competitive standing and your ability to generate above average returns on capital. Hence, BWINB management team focuses on underwriting profitability as the means of generating above average returns on capital and lets competitors worry about market share. So, unless BWINB sees an opportunity to earn a reasonable underwriting profit, they are content with patiently waiting for the market to harden, in the meantime returning excess funds to the shareholders. Over time this approach yielded spectacular results, as the company expanded its earned premiums three-fold over the past 15 years, while generating 95% average combined ratio (which is even lower if viewed on an accident year basis). In addition, in most years BWINB overestimated the eventual loss the company would suffer as a result of accepting the risk, which resulted in substantial reserve redundancies.
It is this “underwriting for profit” philosophy, which is ingrained in BWINB’s organizational DNA, that serves as the company’s main competitive advantage and enables it to generate above average returns on capital. It would be hard for the company’s competition in the fleet trucking segment to replicate this advantage, for the reasons of institutional imperative. It is highly unlikely that an organization that has been permeated for decades with a “write for market share” mentality would, all of a sudden, decide to change its strides. I realize that this replication barrier may, at first, appear to be hard to assess compared to replication barriers such as brand names and distribution systems in, say, a toothpaste or a candy bar business. Nevertheless, I believe that the “institutional imperative” replication barrier is a very real and a very significant one, as I am not aware of any sizeable of insurance companies who successfully switched from the “write for share” to the “write for profit” modus operandi, despite the clear economic benefit of the latter. In a way, this is similar to value investing – the superior economics of value investing have been known for decades, yet the overall percentage of those who practice this trade hasn’t really increased over time.
At the same time, there are a handful of companies in other areas of P&C insurance that pursue the right underwriting philosophy, and those ones may start looking to enter the fleet trucking segment. However, even these firms would face a significant barrier to entry into the segment, namely, the need to spend at least several years accumulating internal historical accident data to build an extensive and reliable underwriting database. Such an internal accident database is necessary in order to underwrite intelligently, for external accident databases available from third-party vendors are notorious for poor data integrity, thus rendering them useless (if not lethal, given the long-tail high-severity nature of large fleet insurance business). For example, it took BWINB decades to build its accident database, which enables the company to make sharp underwriting decisions and stand head-and-shoulders above the rivals.
A few more words with respect to the sustainability of BWINB’s competitive advantage, namely, its underwriting culture described above. In my opinion, one of the main factors that made the company’s superior underwriting culture possible and also the one that ensures the culture’s continuity is the fact that long-term strategic investors together with management own an approximately 45% interest in the company. The controlling nature of this stake enables management to pursue policies that make long term economic sense, as opposed to having to give in to the Wall Street’s pressure to generate short-term gains at any cost.
In addition to BWINB’s organizational setup, which enables superior underwriting, the company has another significant competitive advantage, which is its rock-solid financial condition. BWINB has no net debt, enjoys A. M. Best’s rating of A+ (“
Yet another competitive advantage that BWINB enjoys, albeit it is not as significant as the two outlined above, is its distribution network. As the company writes most of it large and medium fleet business on a direct basis, it enables BWINB to build stronger client relationships, which results in somewhat more favorable competitive economics. In addition, having its own distribution lowers BWINB’s overall cost structure, which enables the company to offer better prices to its clients and enjoy a higher underwriting margins compared to those of the company’s competitors who sell through brokers.
BWINB’s underwriting skill coupled with its superior financial condition should help the company grow its business over time, perhaps significantly. As BWINB’s less efficient and undercapitalized competitors are forced to give up significant chunks of the business, the company should be able to take advantage of it, just as it has done in the past 20 years. BWINB has just 7% share of the large fleet insurance market, which is the company’s main specialty, and there is still room to expand within that segment. In addition, a few years ago the company has entered medium and small fleet markets, which account for 75% and 12%, respectively, of the total fleet market by premium volume. As BWINB gains expertise and builds an extensive accident database in those segments, it should be able to grow within those markets substantially over time. Since BWINB currently faces end markets with a degree of fragmentation and competitive economics, which are similar to those that the company faced in the past, it is likely that BWINB will keep growing its premium volume at about 8-10% annual pace seen in the past 15 years, and its EPS at growth rates somewhat in excess of that due to share repurchases. The previous sentence warrants an important disclaimer: P&C insurance (and fleet insurance in particular) is a highly cyclical business, and one should not expect the company’s growth to occur in a nice smooth manner; rather, it is almost a certainty that BWINB’s long-term earnings growth will feature dramatic ups and downs owing to the industry’s cyclicality and the company’s opportunistic approach to underwriting. One thing worth noting is that BWINB should benefit from tough economic conditions, such as the ones that are currently present. The reason is that during tough economic times investment portfolios tend to shrink and access to capital markets tends to dry up, which results in weakened capital positions of great many insurers. This, in turn, precludes them from underwriting new business, which gives BWINB a chance to pick it up at a significant profit.
INVESTMENT PORTFOLIO
No review of an insurance business is complete without the analysis of the investment part of the business, which is nearly as important as the underwriting part of the business. BWINB scores well on the investment front, as the company strictly adheres to its long-standing policy of investing in a highly conservative manner.
Fixed income portfolio, which accounts for about 80% of the total investment portfolio, is comprised mainly of U.S. Government and municipal bonds (over 90% of fixed income portfolio), with the remainder invested primarily in debt instruments of foreign governments, higher quality corporate bonds, and mortgage backed securities.
BWINB’s equity portfolio (which includes the LPs the company invests in) is managed based on a long-term buy-and-hold strategy. Through 2007 the equity portfolio outperformed the S&P 500 by approximately 1.5% per annum on a long-term basis net of fees. This suggests BWINB conducts its equity portfolio management in a satisfactory manner.
DISCUSSION OF POTENTIAL BALANCE SHEET RISKS
BWINB faces two significant potential balance sheet risks, which, although remote in my opinion, are worth reviewing:
The first risk is credit risk that the company faces from its largest client, FedEx. The customary terms of a large deductible policy are such that BWINB pays the entire amount of the claim before it gets reimbursed by the client for the amount of the deductible. This gives rise to credit risk, unless the exposure to deductibles is collateralized. While BWINB normally collateralizes its exposure to deductibles, the company is undercollateralized with respect to its exposure to Fedex, BWINB’s largest customer. The uncollateralized exposure to FedEx is about 25% of the company’s book value. However, for BWINB to take the full 25% hit the following two things have to happen at once:
1. All the business written for FedEx has to register maximum losses within a relatively short period of time;
2. FedEx has to declare bankruptcy during that relatively short period of time; further, the bankruptcy must be such that BWINB receives no proceeds whatsoever (despite being senior to bondholders and shareholders).
The chance of each of the above happening on a stand-alone basis is very small, and the chance of both happening at the same time is yet smaller by a significant degree (even though there may be some correlation between the two). Yet, even if the unthinkable happens, and the maximum loss of 25% of book value is realized, the company should easily withstand the hit and will still be trading at a discount to book at current prices.
The second potentially significant risk has to do with BWINB’s reinsurance arrangements, which the company uses to lay off a portion of its risk onto third-party reinsurers. The exposure to the reinsurers’ defaults appears to be extremely low, as most of BWINB’s reinsurers boast A. M. Best’s rating of A+ (“Superior”) or A (“Excellent”), while BWINB altogether avoids dealing with reinsurers whose A. M. Best’s rating is lower than A-.
MANAGEMENT AND OTHER INSIDERS
BWINB has a highly qualified and reputable management team at helm. The company’s CEO Gary Miller has been with the company since 1965 and clearly “lives and breathes” the “for profit” underwriting culture, which is a cornerstone of a successful property and casualty operation. Under his watch (he has been the CEO since 1997) BWINB has grown premium volumes nearly three-fold while generating average combined ratio of less than 97%, thus significantly outperforming most of the company’s P&C peers. While the CEO is 67, BWINB has a sound succession plan in place, as another company veteran, Joseph DeVito, is ready to step into Mr. Miller’s shoes. Mr. DeVito has been with the company since 1981, most recently as COO and President, and he adheres to the same school of conservative profit-driven underwriting and opportunistic approach to growth. CEO’s compensation is somewhat above average, but given Mr. Miller’s stellar track record of value creation the above-average pay package is definitely justified. CEO has a 1.5% stake in the Company; COO and CFO own another 1.0% and 0.5%, respectively. Management performance compensation is based on profitability and long-term growth in book value, thus further aligning the interests of management with those of the shareholders. Historically management has followed a generous dividend policy, while also repurchasing shares when they were selling below fair value. In the recent months BWINB stepped up its buyback program as the stock fell well below its intrinsic value; further, a couple of the company’s executives started purchasing BWINB shares for their personal accounts.
In addition to management the ranks of significant long-term investors in BWINB include the Shapiro family and Mr. John Weill, who own 26% and 21% of total shares, respectively, and enjoy significant board representation. Both parties have been on the shareholder roster for a long time, understand insurance business well, and thus serve as an important safeguard of the company’s conservative profit-focused culture against the Wall Street pressure.
Proxy statement reveals a number of related-party transactions between BWINB and some of the businesses owned by the board members related to the Shapiro family. I don’t see this as an issue, as a 20% increase in BWINB stock price would boost the Shapiros’ wealth by about $12 million, whereas an identical increase in fees derived from BWINB would boost their wealth by just $0.36 million. These statistics make it clear that the Shapiro family interests are lodged with increasing the value of BWINB as opposed to milking the company for fees. In addition, BWINB gets a discount on fees while investing with and trading through the said entities, so the company gets a better deal than if it went through an unaffiliated third-party. Further, the long-term performance of the company’s investments managed by the firms affiliated with the Shapiro family has been rather decent, so dealing with the family-related entities has not been a value subtracting affair from the shareholders’ point of view.
It is worth mentioning that BWINB has two classes of shares: A Class (Ticker: BWINA), which come with voting rights attached to them, and B Class (Ticker: BWINB), which are not entitled to vote. I don’t think this is an issue, because directors and executives have their holdings diversified between the A and the B shares (they own 69% of the As and 38% of the Bs). Another reason why I don’t think dual class structure is an issue is that the shareholders of both share classes have been treated well and they have seen the value of their stake in BWINB increase significantly over time. There is not much of a price difference between A Class shares and B Class shares; however, the latter are a lot more liquid.
VALUATION
There are several different angles from which you can examine the BWINB valuation: (a) multiple of normalized earnings, (b) book value, and (c) cash extraction value. Whichever method you use, it appears that the stock is significantly undervalued:
A. MULTIPLE OF NORMALIZED EARNINGS
Since insurance business is highly cyclical owing to the lumpy nature of both underwriting and investment parts of the business, reported earnings in any given year may be far off from the sustainable “intrinsic” earnings. Therefore, to calculate a sustainable earnings number you have to normalize current earnings based on certain assumptions regarding the firm’s long-term underwriting profitability and investment portfolio performance. Based on my set of assumptions, BWINB trades at just over 6X CFY multiple of “normalized” earnings, which indicates that the stock is significantly undervalued.
Obviously, the earnings estimate on which the above multiple is based is only as good as the set of assumptions, and therefore I will discuss the most important of them below:
- Underwriting profitability. I am assuming that BWINB will be able to generate a combined ratio of about 95% over the long-term. This is the average combined ratio that the company has generated over the past 15-year period, which includes a multitude of soft and hard markets, and, therefore, makes the historical ratio a good baseline for estimating future long-term results. As all the past elements of the disciplined underwriting culture are still present in the BWINB organization, is it a reasonable to assume that long-term future combined ratio will approximate the one observed in the past.
- Rate of return on the company’s equity portfolio. I am assuming a 9% pre-tax long-term return on BWINB’s equity portfolio from this point on. I am not an expert in macroeconomic forecasting by any means, but I fairly certain that 9% is a solid conservative number given that: (a) current PE of the S&P 500 of 12X is significantly below its long-term average of 16X, (b) long-term historical average rate of return of the S&P 500 is about 9%, and (c) the company has shown an ability to outperform the market (albeit by a small amount) using a long-term buy-and-hold investment philosophy.
- Rate of return on the company’s fixed income portfolio. I am assuming a 5.5% pre-tax long-term return on BWINB’s fixed income portfolio. Again, I am not an expert in macroeconomic forecasting, but I am fairly confident that 5.5% represent a solid conservative assumption because: (a) a long-term historical average for a 10-year Treasury note is between 6% and 8% (even though it has been below 4% recently), (b) current inflationary economic policies pursued by the U.S. are likely to push the rates up towards historical averages, if not higher, over the longer term, and (c) the company invests a large portion of its portfolio in munis, which offer a somewhat higher tax-adjusted yield than treasuries.
- I am including both realized and unrealized investment gains in my normalized economic earnings estimate. While per U.S. GAAP you should exclude unrealized gains from the calculation of earnings, I am including both types of gains, as they both represent economic earnings of the business.
- I am calculating the company’s market cap net of cash on the balance sheet, because this cash is essentially “excess” in nature and it may be transferred to the parent company without prior approval by regulatory authorities. A large percentage of this excess cash will likely be transferred to the parent company and used for dividends and share repurchases.
Here is a back-of-the-envelope calculation that details the main inputs of the normalized earnings number:
2008E
Earned premiums, net………………….$180.0 million
Service fees, etc, net (after tax)……..........$2.8 million
Underwriting profit (after tax)....................$5.9 million
Equity (R) (after tax)……………..............$8.0 million
Fixed income (R) (after tax)…………….$15.0 million
NORMALIZED NET EARNINGS….....$31.7 million
Market cap: $248 million net of $48 million in cash = $200 million.
In addition, at the current price BWINB stock sports a dividend yield in excess of 6%.
B. BOOK VALUE
This one is a lot simpler than the previous one. The company’s market cap is about $250 million. The company’s tangible book is about $345 million. Historically, the company overestimated its losses by about 15%, on average, so making adjustment to BWINB’s loss reserves to account for that yields a “true” book value of $380. (In addition, given the recent significant decline in the stock market, there is a good chance that the company’s equity holdings are selling below their fair value, making the “true” book value still higher, but I am ignoring this positive effect for the sake of conservatism.) Based on the above statistic BWINB stock is selling at a discount of about 35% to its “true” book value, which indicates a significant degree of undervaluation.
C. CASH EXTRACTION VALUE
If BWINB chose to do so, it could dividend out about $260 million over to the shareholders tomorrow, and the company would be able make that disbursement without incurring any debt. ($215 million of that would have to be approved by regulatory authorities, but given the company’s rock-solid financial condition it wouldn’t be a problem, most likely.) As BWINB’s current market cap is about $250 million, investors buying the stock today would be effectively getting paid $10 million in exchange for assuming ownership of the operating business – albeit a weakened one with a very limited growth potential – capable of generating about $20 million in earnings per year. This cash extraction value, which is significantly in excess of the current market cap, further highlights the dramatic undervaluation of the company’s shares.
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