Conseco, Inc. CNO
October 06, 2003 - 4:15pm EST by
lindsay790
2003 2004
Price: 19.62 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 1,962 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Conseco, Inc. (NYSE: CNO; recent share price $20.00) is a post-bankruptcy pure play insurance company with a strong market share in the high growth senior and Hispanic sectors of the market. Conseco is attractively valued at approximately 7x its 2005 earnings potential. “Hidden” value of more than $500 million ($5 per share) may exist through NOLs.

Background

Post-bankruptcy and the sale of its finance business, f/k/a Green Tree, CNO is a pure play insurance operation. The company’s principal product lines are in the supplementary health area: Medicare supplemental insurance; specific disease insurance, such as for cancer and heart disease; and long-term care insurance. CNO also sells annuities and life insurance, including equity-linked products, an area in which Conseco claims some expertise. CNO operates primarily under two brand names: Bankers Life and Casualty Company, which covers the senior market through its wholly-owned agent force, and the Conseco Insurance Group, which covers a broader range of customers through both wholly-owned and independent marketing organizations.

CNO’s business was hit hard by the bankruptcy process with downgrades by AM Best and other agencies, the departure of agents, the need to offer higher commissions to retain agents, increased policy redemptions, and overall negative perception in the marketplace all compromising the company’s ability to sell and renew policies, particularly annuities. In addition, with a relatively low level of statutory capital at its insurance subsidiaries, CNO was hindered from selling products requiring a reduction in statutory capital at the time of the sale, such as annuities with high up-front commissions. Also, CNO has experienced loss ratio problems with certain long-term care policies.

Many of the problems the Chapter 11 process caused for CNO are now behind it or, at least, are not having any further negative impact. As an illustration, lapse rates in the most recent quarter stabilized. Going forward, CNO’s emergence from bankruptcy should encourage new sales and stabilize and motivate the agent sales force. Also, CNO’s prospects should be enhanced by a focus on building regulatory capital and surplus, and improving credit ratings. The recent sale of the GM Building in New York with a statutory capital gain of $380 million is a clear positive in this regard.

Capitalization Profile

CNO has issued three publicly-traded securities, all of which are attractive investment opportunities: CNO’s common stock offers upside of at least 50% to 75% from current levels over an 18 to 24 month time frame. CNO also has issued warrants (expiring in 2008) to purchase common stock with an exercise price of $27.60. The warrants are NYSE listed (symbol CNO/WS) and offer a higher risk/higher reward way to play CNO. CNO’s convertible preferred stock (symbol CNSJP) offers returns of 10.5% for the more risk averse. The preferred stock is redeemable at any time and, given its high dividend rate, will probably be redeemed within the next two years.

Recent common stock price $20.00
52 week range $17.70 to $22.50
Shares outstanding 100 million

Recent warrant price $6.25
52 week range $4.90 to $6.60
Warrants outstanding 6 million

Recent preferred stock price $25.00 (per $25 face amount)
52 week range $24.00 to $25.15
Shares outstanding 34.4 million

Significant common owners Appaloosa (21.5%, prior to distribution to LPs), Angelo Gordon

Management ownership 10%

Equity market capitalization $2.0 billion
Preferred stock $860 million
Debt $1.3 billion

Key Investment Considerations

Turnaround Potential – The most important element of my investment thesis is that Conseco should be able to regain (if not surpass) its pre-bankruptcy revenues with earnings to match over the next 18 to 24 months. After all, CNO’s operations today are the same as the “continuing operations” from pre-bankruptcy days. If anything, the bankruptcy process has streamlined operations and the company should have significant earnings leverage to revenue gains over the next few years. The most important driver of this turnaround is an improvement in CNO’s credit ratings and statutory capital. (This is particularly important with respect to selling annuity products.) To get a feel for how important this is, imagine the difference in the “kitchen table” sales pitch to Mr. and Mrs. Senior when the sales person can say that his employer has an A rating versus having to admit that your parent company is in bankruptcy and carries a B rating. CNO is currently reporting that business is “good.”

Growth – The two market niches in which Conseco has a strong presence are for (i) seniors, which has a projected population growth of 17%, and (ii) Hispanics, which between 1990 and 2000 grew at seven times the rate of the US non-Hispanic population and is expected to continue to grow rapidly.

Limited Competition – Both of the market niches in which CNO has a strong presence are relatively uncompetitive: For seniors, Conseco sells mainly to middle market, middle income Americans with income levels of $25,000 to $75,000, a demographic that has not been targeted aggressively by competitors. For Hispanics, the market is underserved in general.

Cost Savings – Conseco is an amalgamation of insurance companies, many of which were acquired in the late 1990s. Five were acquired in just 1997: Washington National, Colonial Penn, Providential Life, Pioneer and Capital American. These acquisitions were not fully integrated from an operational standpoint. Consequently, Conseco has a number of redundant systems and people that may be eliminated from its cost structure. With some $600 million of “other operating costs and expenses,” I think $30 million (5%) of cost savings are possible.

Clean Book of Business – With principal business lines in the supplemental health, life and annuity areas, Conseco has a relatively conservative portfolio of insurance liabilities. In particular, CNO has no exposure to asbestos, D&O liabilities, or hurricanes, just to mention some of the popular miscreants in the insurance world. This should add to the future stability of CNO’s earnings and should argue for a higher trading multiple.

New, Conservative Investment Strategy – Owing to its lack of statutory capital, CNO has been forced to adopt a more conservative investment style. As a result, earnings volatility from the asset side of the balance sheet is likely to be lower than in the past. Specifically, volatility from investments like those the company made in Enron, Global Crossing, K-Mart, Sunbeam, UAL and WorldCom are less probable in the future.

Take Out Potential – With a strong presence in two high growth niche markets, well-regarded distribution, and a “mid-cap” valuation, Conseco is an attractive acquisition candidate for a larger insurance player.

Valuation

The basis for CNO’s reorganization was a total enterprise value of $3.8 billion which corresponds to an equity valuation of $1.64 billion or $16.40 per share. The use of this valuation during the bankruptcy process was a major concern to holders of the old Conseco’s TOPrS preferred stock who argued the low value unfairly reduced their recovery. After some interesting discussions, the TOPrS holders were able to extract a larger share of the post bankruptcy equity plus warrants. I think the TOPrS holders, who argued for an enterprise value of $5.9 billion ($37.40 per share), had a good case, notwithstanding their self-interested negotiating position. Some of the reasons are:

1. The projections on which the reorganization value was based were prepared at the start of 2003 when the outlook for CNO was worse than it is now.
2. The valuation excluded certain NOL benefits worth over $500 million as indicated in a report prepared by Fox-Pitt Kelton, a boutique investment bank that specializes in financial service companies, that was hired by the TOPrS Committee. This valuation can be viewed at http://docs.bmccorp.net/conseco/docs/3944.pdf. According to the company, CNO has about $400 million of capital losses, some of which will be used to offset gains on the sale of the GM Building, and about $1.9 billion of operating losses, the majority of which are subject to restrictions for use in insurance operations. Another $4 billion of carry forward losses may result from the sale of the sale of the old Conseco finance operations. The exact nature of these losses (capital versus operating, life versus non-life) is not yet clear. Conseco is discussing these losses with the IRS and should be able to determine its future tax status by the time it files tax returns for 2003 (September 2004) if not before. In any event, CNO is not likely to be a full taxpayer in the near future, and a $500 million value for CNO’s tax attributes may turn out to be conservative.
3. FPK also prepared a valuation of CNO in its entirety for the TOPrS Committee. This was a private market valuation that valued the company at $4.9 to $5.5 billion ($27.40 to $33.40 per share) although it did not attribute any value to CNO’s tax attributes. This report can be viewed at http://docs.bmccorp.net/conseco/docs/3758.pdf.
4. Similarly, a valuation prepared in December 2002, but as of June 30, 2002, by Milliman, the actuarial firm, valued CNO’s insurance business at $3.4 to $5.3 billion ($12.40 to $31.40 per share), excluding the impact of corporate activities and any NOLs. This report can be viewed at http://docs.bmccorp.net/conseco/docs/ds_Milliman_Valuation_Report.pdf.
5. Since the balance sheet date of the reorganization valuation, September 30, 2002, CNO’s investment portfolio has increased by over $1 billion as of June 30, 2003. Keep in mind these gains are, in part, due to interest rate reductions that will be offset by corresponding increases in insurance liabilities. However, the increase in value excludes the recent gain from the sale of the GM Building. Further, I find it hard to imagine that the recently realized sale price would have been factored into the reorganization value prepared almost a year ago. The gain in statutory capital for this transaction was almost $4 per share. No GAAP impact will result from this sale as the $16.40 per share reorganization value is deemed to include this gain.

What does this all mean? A number of experts have produced recent reports suggesting the value of Conseco is meaningfully higher than the $16.40 reorganization value. Given that both management (because of their post-transaction ownership) and creditors (in order to cram down junior claimants) have an incentive to argue for a low valuation during bankruptcy, these data points are important benchmarks that make a strong case for a higher stock price today.

What should CNO be worth?

On an annualized basis, I think CNO should be able to generate around $2.75 to $3.00 per share of net earnings in 2005, estimated as follows:

1. Given the growth potential of CNO’s target markets, ratings agency upgrades, and a “bounce back” from being in Chapter 11, I think revenue growth of 5% per year over the next two years is conservative. Growth at this rate leads to 2005 revenues of $5.5 billion, assuming no surprises in terms of net investment income.
2. I assume an operating margin of 12.5% to give me operating income of $687.5 million. By way of comparison:
a. With similar revenues in 2000 and 2001, CNO produced operating earnings of $777 million and $781 million. Although for true comparability, these results should be reduced by $100 million for continuing losses in the long-term care business. This is roughly the increase in policy benefits for the long-term care book from 2001 to 2002, excluding a $130 million one-time charge. It’s worth noting that over time, the unprofitable long-term care book should get less unprofitable as the company works with state insurance regulators to obtain premium increases. Note also that fresh start accounting will impact future margins, so pre- and post-bankruptcy comparisons are difficult.
b. Margins in the Chapter 11 disclosure statement are consistent with this level, ranging from 12.4% to 15.2%.
c. Companies like JP (Jefferson-Pilot), TMK (Torchmark) and PL (Protective Life) are more profitable with higher margins. AFL (AFLAC) has comparable profitability. Other companies like MET (MetLife) and ANAT (American National) are less profitable.
d. CNO’s most recent quarterly operating earnings were around $50 million, giving a run rate of about $200 million. The implication is that with revenue growing to $5.5 billion much of the revenue gain would need to drop to the bottom line. Impossible, no. Aggressive, maybe. Possible, yes – much depends on exactly how much the bankruptcy process has impacted broker productivity, the level of cost savings that CNO may be able to achieve going forward, and the level of Chapter 11 “noise” in the recent results.
e. Although the company has not released any guidance as to future earnings, when asked, they did not dispute the fact that the 2000 and 2001 operating earnings from continuing operations mentioned above would be a good “starting point” for determining CNO’s earnings potential in a post-bankruptcy world.
3. Using the $687.5 million result, deducting $97.5 million of interest (at a 7.5% rate) results in pretax income of $590 million. After deducting taxes of $212.4 million at the 36% disclosure statement rate (which assumes no NOLs) and preferred dividends of $90.3 million results in net income $287.3 million, before the impact of options. 100 million shares outstanding results in EPS of $2.87. A range of $2.75 to $3.00 seems appropriate.

What’s the correct multiple? Most insurance companies (of which there are no great comparables) trade in a range of 10x to 15x current year net income. Using the bottom of the range results in a $27.50 to $30.00 per share price. Keep in mind this does not give the company any credit for its NOLs (maybe another $5.00 per share or more) or for the potential redemption of its convertible preferred stock, which, with a 10.5% dividend or a 16.4% pretax cost of funds, would be an accretive transaction. I also think that with the growth potential of CNO’s market niches, 10x is being conservative. However, because being conservative is prudent, but including at least some benefit for the NOLs, I think CNO should trade at $30.00 to $35.00 per share within an 18 to 24 month time horizon.

Further, a $30.00 target is equivalent to 1.8x the reorganization book value, which is probably artificially low for the reasons outlined above. The average for the insurance company universe today is around 1.5x current book. Using this multiple would get to a stock price in the mid $20s.

Words of Caution

From an operating standpoint, CNO’s most significant problem area is the part of its long-term care book originally acquired in 1996 with American Travellers. This portfolio may take sometime to manage to profitability. The problem policies at this point account for less than half of CNO’s long-term care business or about 5% of all of the company’s collected premiums.

Other operating and execution risk exists.

The convertible preferred conversion price is set as the volume weighted average CNO common stock price for the period 60 to 120 days following CNO’s exit from Chapter 11. This price setting mechanism may cause some downward pressure on the stock. Further, while the convertible preferred is not convertible until two years after the bankruptcy exit, if it is not redeemed, meaningful dilution could occur.

Additionally, judging by recent trading, a number of CNO’s new shareholders may not be long-term natural holders of the stock. These types of sellers may depress the price for a while.

Catalysts

1. Any rating agency upgrade.
2. Initiation of analyst coverage - both of these events are possible after the filing of either the September 10-Q or the 2003 10-K which will be the first official documents that present Conseco on a post-bankruptcy basis.
3. Redemption of the convertible preferred stock.
4. Resolution of the exact NOL position with the IRS.

Catalyst

1. Any rating agency upgrade.
2. Initiation of analyst coverage - both of these events are possible after the filing of either the September 10-Q or the 2003 10-K which will be the first official documents that present Conseco on a post-bankruptcy basis.
3. Redemption of the convertible preferred stock.
4. Resolution of the exact NOL position with the IRS.
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