Description

I again recommend a long position in Endurance Specialty Holdings (at the risk of being repetitive - I call it consistent!), a Bermuda-based property and casualty company formed during the capital shortage that followed 9/11. I wrote up the company last August (when the price was about $28), and while the fundamentals have improved even more than I estimated then, the stock price has only increased 15% (although it did visit a high price of $37 in the interim).

You can read my August ENH report on VIC for the general business details, but there are two important changes (both positive) that I would emphasize:

(A) First, the company has beat my operating estimates .. ENH has grown premiums faster than I had anticipated, while concurrently improving its combined ratio.

1Q03 2Q03 3Q03 4Q03 1Q04

Net Earned Premiums
% Change from Comp Q 190% 293% 201% 116% 119%
Combined Ratio 83.4% 84.1% 88.4% 82.5% 81.6%

Operating EPS $0.75 $0.91 $0.81 $1.28 $1.44
(excluding Capital Gains)

As a footnote, premium growth will be lower in 2Q04 because of the anniversary of the Hartford Re book of business acquired in 2Q03.

It would seem reasonable to expect Operating EPS for 2004 of $5, giving a current P/E of 6.6x

Note that the combined ratio has benefited from some recapture of losses overestimated in the prior year (a good sign that the company is conservative in estimating current losses).

1Q03 2Q03 3Q03 4Q03 1Q04
Prior Year EPS Benefit $0.12 $0.13 $0.17 $0.13 $0.28

These profits helped, but did not "make" these periods, so the story remains unchanged even if you back them out (which you would not do if you expect comparable Prior Year Benefits related to current periods in the future).



As a result, while the company has projected ROE in the 15-17% range, it beat that range with an ROE of over 20% in 1Q04.


(B) Rising interest rates should help EPS

The company has kept its $3 billion portfolio concentrated in short-term high quality fixed income securities. With every 1% rise in short-term rates (and therefore yields on the portfolio), EPS should improve by $30 million per year, or an EPS increase of $0.47 (the company pays minimal taxes because of its Bermuda domicile). If you believe (as I do) that short-term interest rates could rise 2-3% over the next two years, the EPS impact should be considerable.


Cautions:

(A) The business is lumpy, particularly with hurricane-related losses in the third quarter. The recent past has been relatively free of large catastrophes.

(B) Private equity firms TPG and Thomas Lee own large stakes, and may put a ceiling on the stock through their selling, but value should eventually win out.


Valuation:

Ultimately P&C companies trade on some mixture of P/E and Book Value multiple. From a current BV/share of $25.51, I would project BV/share of $33 by year-end 2005. A 1.5x P/B (reasonable for a company with lumpy ROE over 20%) would yield a price per share of $50 (and a P/E of 10). So a 12 month upside of 50% seems achievable.


Sorry about the simple explanation .. it is a simple story.

Catalyst

Earnings, earnings, earnings ...
Rising interest rates
The company makes a real effort to get its story out with investment conferences, etc ... one day, investors will pay attention.