Description

Endurance Specialty Holdings, a P&C insurance and reinsurance company, has a profitable business with quality management selling at an attractive valuation because of a temporarily depressed stock price. This is a simple investment thesis: when the selling associated with the expiration of the lock-up period is complete, the stock will rise to its intrinsic value and/or trade in line with comparables, with significant upside and minimal permanent downside from here.

Endurance writes specialty lines of P&C insurance and reinsurance on a global basis. It was formed in December 2001 after the World Trade Center disaster by Aon, the world largest reinsurance broker and several private equity sponsors including Texas Pacific Group and Thomas Lee.

General background
The property and casualty business (P&C) has historically been characterized by years of famine (poor pricing) followed by a catastrophic event that causes large industry losses, leading to years of feasting (high rates) for the survivors. The WTC disaster (and subsequent weak global equity markets) caused the destruction of over $100 billion of insurance industry capital, resulting in an immediate capital shortage and a strong rise in pricing. As in the early 1990s following the huge losses associated with Hurricane Andrew, several insurance/reinsurance companies were formed since September 11 in Bermuda in order to profit from the rise in insurance rates. These companies, usually with one or more billion dollars each in new capital, are formed when an industry sponsor (usually a large insurance broker) agrees to provide new business, equity sponsors provide the capital, and an experienced management team is recruited to write new business. The major advantage for the new investors is the absence of legacy issues (the future profitability of the business is devoid of any historical losses), combined with the benefits from improved industry pricing, as the historical players in the industry raise rates to recover from their losses.

Short Term Valuation Opportunity
ENH went public on February 28, 2003, and its six month lock-up period ends on August 27. Fears of a spate of insider selling resulting from the lockup expiration have put recent pressure on the stock, causing it to trade below its intrinsic value and below its peers. I do not believe insiders, who are quite sophisticated private equity firms, would sell at this low valuation. This is a short-term opportunity to make an attractive long-term investment.

Fundamentals
Rather than repeat historical information available from public filings, let me focus on the immediate future. While perfect precision is impossible, I believe my projections are directionally correct.

This can be a somewhat lumpy business, but generally speaking, ENH prices business so as to earn an ROE of about 15% (although last quarter it earned an ROE of 17.3%). Based on a 6/03 book value of $22.68, ENH should have EPS of approximately $3.65 over the next twelve months and $4 in 2004. A reality test is that ENH earned $0.44 IN 3Q02, $0.65 in 4Q02, $0.78 in 1Q03 and $0.94 in 2Q03. Book value should approximate $28 at the end of 2004.

Valuation
ENH is currently trading at 10x LTM EPS; 8.3x 1H03 annualized EPS; 7.1x 2004E EPS.
ENH trades at 1.25x 6/03 book value and 1x yearend 2004E book value.

A reasonable target would be $40 per share (10x 2004E EPS or 1.4x yearend 2004E BV)

Comparing ENH to two other recent Bermuda insurance IPOs, Axis and Montpelier both trade at 1.5x 6/03 P/B.

Endurance seems to confirm the attractiveness of the current stock price by agreeing to repurchase 750,000 shares last week from one of its founding shareholders, TIAA-CREF, at $27.06.

Positives

Strong industry fundamentals
Solid balance sheet ($1.5 billion in equity and $141 million in debt)
Strong P&C expertise in underwriting staff
No legacy issues
Untapped earning power, as ENH has not yet written business up to the capacity of its capital
Recent small acquisitions show intelligence and creativity
Large sophisticated owners in the form of TPG, Thomas Lee, etc.
Low tax rate (Bermuda)
Excellent disclosure, according to industry analysts

Negatives

Duration of the P&C pricing cycle is always a little unpredictable, although the recent extreme capital destruction should sustain the current cycle for a few more years
Inherent volatility in earnings due to unpredictable “insured events”
New company, lacking a long history
A large number of similar companies were started in Bermuda in the last few years, and while only a handful are public, additional IPOs could increase the supply of alternative investment choices

DISCLOSURE
At different times, I may or may not have a long position in the stock.

Catalyst

Subsiding fears about insider selling after expiration of the August 27 lockup expiration and the absorption by the market of any insider shares sold