Description

Endurance has been written up twice by ladera--most recently on May 10. I commend both notes to interested readers as very helpful background. While the price has hardly budged in the seven months since (the stock is up $1.00), I believe that Endurance is a more compelling story today for three reasons, in summary: (1) Terrific operating results in two ensuing quarters, most notably in Q3 when the industry was decimated by the series of Florida hurricanes and Japanese typhoons; (2) AON recently sold 9.8MM shares (roughly 70% of its position), both expanding the float and reducing future overhang; and (3) Business changes brought on by the Spitzer investigations should at worst be a neutral and conceivably a significant positive.

Ladera details ENH operating results though the March quarter in the May recommendation. In June, net earned premiums were up 35%, the combined ratio dropped to 76.9, and operating EPS reached $1.74. The company bought back 2.16MM shares in May at $31.78 and authorized an additional program of 2MM through May, 2006. Results were boosted by $41MM ($0.62/share) of positive prior year reserve development. Even excluding this it clearly was a superb quarter. I'm not sure that one should exclude it, however, as ENH has had quarter after quarter of releasing reserves. I think it really bears testimony to the innate conservatism of management. On the conference call, the Chief Actuary noted that no one truly understood how much benefit accrued from the post 9/11 tightening of terms and conditions.

Given the huge industry losses in the third quarter (an estimated $20 billion from the hurricanes), the company's performance, while obviously weaker, is perhaps even more impressive. Net earned premiums climbed 22%, the combined ratio was 103.0, and operating earnings were $0.36. Prior period reserve releases were $51MM, or $0.77/share. Net catastrophe losses were $115MM: $1.74/share. I wouldn't look at it this way, since the reserve releases are real and so are the catastrophes, but you could take both numbers out and conclude that ENH earned $1.33, or an annualized rate of $5.30. One reason ENH fared better than the industry in general--despite a fair amount of property catastrophe reinsurance and excess of loss in its book--is that the company purchased additional reinsurance for Florida earlier in the year. Taking the first three quarters as a whole, the annualized ROE was 18.7%--ahead of the 15-17% stated goal for the year. Fully diluted book reached $26.69, up 15% year to year even with a meaningful buyback and dividend.

Two weeks ago, AON, a sponsor of the company in late 2001, sold its shares in a block trade (it retains about 4MM warrants). Of note, Perry Partners, also an initial investor, purchased 1MM shares on the print at $32.90. As a consequence, the float is now over 50% of the shares out. Besides Perry, other significant holders are Texas Pacific, Tom Lee, and Capital Z Holdings. I think the other benefit of the sale is that to the extent Endurance was seen in the market (and this is hard to gauge) as a creature of AON, other insurers and brokers may be even more comfortable doing business with it. Through nine months, AON represented 35% of gross premiums written for ENH while Marsh Mac was 28%.

CEO Ken Lestrange believes (articulated at a Lehman reinsurance conference in early December) that the consequences of the Spitzer investigations will be positive for Endurance. He pointed out that more broker and carrier relationships will likely be shopped, which tends to work against the more established providers and for the newer entities. Moreover, a sharp reduction in the use of finite risk structures, of which there is already some evidence, should lead to greater demand for traditional reinsurance products. I'd like to think he's right, but I'm at least pretty sure that the changes in business norms brought about by Spitzer will not be a negative.

Endurance has a pristine balance sheet. Debt/cap is 12% (this spring the company issued $250MM of 7% 30 year notes. Invested assets total almost $3.6 billion ($54/share), are 98% fixed-income (nothing below an A rating), and have a duration under three years. IBNR represents 80% of total reserves. S&P recently upgraded its rating for Endurance. Operating cash flow has exceeded $300MM in each of the last two quarters, and $1.1 billion over the past year; while the rate will likely slow the company is expanding its investment portfolio meaningfully. Annualized investment income in Q3 was $1.86/share. Higher rates would be a significant benefit to ENH, while they would weaken the competitive posture of a significant portion of the industry.

The business outlook is fair to good. Management refers to their strategy as one of stock picking rather than indexation--a willingness and a proven ability to enter and exit niches depending on available risk-adjusted returns. While certain business lines have clearly softened in recent months, others have stablized after the hurricane and Japanese typhoon losses.

Especially with the willingness and ability of management to buy back stock under 1.3-1.4X book (current price/book is 1.27 fully diluted), I believe ENH can continue to earn a mid-high teens ROE over the next couple of years. This translates into $5 in EPS and a book value that should be in the mid-high $30's by the end of 2006. Currently, ENH trades toward the low-end on a price/book basis of the P/C companies created in the aftermath of 9/11. Axis and Montpelier both currently trade between 1.4-1.5X book. I think this is a very reasonable target valuation, which implies that a fair target for Endurance is in the low $50's two years out. Coupled with a 2.5% yield, this yields a compounded return north of 20%--which I don't think is accompanied by enormous risk. The history of Bermuda insurers is that the decent companies don't trade below book for very long: Here book should be $32 or so 12 months out. I think the risk/reward is really compelling.

Risks:

1. Reserves. Buffett has observed that reserve setting is like a self-graded exam.
There's tremendous temptation to cheat. Furthermore, history suggests that there's always more that you don't know then you do know. While there are lots of good signs regarding the reserves at Endurance you never really know.

2. The cycle. For almost every line the second derivative has already changed for the negative and in many lines premiums are actually decreasing. The only counter I can offer is valuation and the example of a stock like Renaissance Re, which contined to put up good numbers in the late 1990's despite a soft market and rewarded investors handsomely.

3. Industry turmoil from the investigations. I explained above why I believe it's no worse than a neutral but I could be wrong. It's happened before!

Catalyst

1. Earnings.

2. Higher interest rates.

3. Further industry consolidation