Summary

First Mercury Financial (FMR) is a insurer that concentrates on a handful of specialty lines. They focus on writing relatively small premium non-standard policies, which have helped them to avoid competition from many of the larger players. The company has been around for over 36 years, and it has evolved through a handful of strategic acquisitions. FMR IPO'd in late 2006 and has managed to compound book value per share at 23% annualized over the 3 years ending 12/31/09 (during the 3 years prior to its IPO, it generated a 29% average annual ROE). Even given the shorter time span of this combined track record, those are results few insurance companies could match over the same period.

Despite this excellent historical performance, the most compelling factor in this situation is the current price. Based off 1Q10 diluted book value per share (BVPS) and the current market price of $10.69, FMR is trading at 0.65x book. Price to tangible book isn't much higher, at 0.79x. If the company only traded back to its 1Q tangible book, and ROAE was 0%, from this price you'd make an absolute return of 28%. This is for a company that generated $2.25, $2.18, and $2.48 in diluted EPS for 2007, 2008, and 2009. Taking the insurance side of the business out of the equation, you're essentially buying $43/share in investments for $10.64--this is up substantially from the end of 2008 when you could have paid $14 for an investment portfolio of $29/share, which should help to create decent investment income.

The management team owns approximately 19% of outstanding stock, and has made multiple shareholder friendly decisions. From August 2008 to 2009, they authorized and completed a stock repurchase program for 1.5M shares which was approximately 8% of shares outstanding. When that ended, they authorized another 1.0M buyback (6% s/o) for the period through August 2010 but they haven't yet repurchased any stock under that plan. Any share repurchases at these prices will be accretive to both BVPS and Tangible BVPS, but it should also increase forward EPS as well.  More recently, they paid a special $2.00 dividend on 3/31/10. Each of these measures demonstrates management's openness to enhancing long-term shareholder value while taking advantage of their depressed stock price.

At the beginning of July, FMR announced that they intend to purchase Valiant Insurance Group from Ariel Holdings for tangible book value. The acquisition, although not monumental in size, should allow First Mercury a chance to continue growing underwriting float, investments, and profits per share.

Background

First Mercury has operated mainly as an Excess & Surplus (E&S) underwriter. This means they'll underwrite non-standard business that state admitted/standard carriers don't want. FMR and other non-admitted carriers would be restricted from selling products already covered by an admitted carrier, but they in turn have greater flexibility to alter coverage terms which includes more freedom to adjust premiums. The company has always targeted smaller premium policies.

CoveX was the only insurance underwriting entity for First Mercury and its predecessor up through 2000. It has concentrated on policies for security guards/detectives, alarm installations, and safety equipment.  Due to a B+ credit rating, FMR was unable to directly write insurance policies itself; instead it utilized fronting relationships where CoverX would produce policies, an admitted carrier would actually underwrite them, and then FMR would absorb the policies through a reinsurance arrangement and/or cede them out to other reinsurers. This involved FMR paying a fronting fee which negatively impacted profits, but it was the only way to get around the credit rating issue.

In 2004, Glencoe Capital (which runs a lower middle-market PE firm based in Michigan) injected $40M of capital into the company through a preferred convertible offering. This bumped FMR's credit rating up to A- and gave them the ability to bypass the fronting relationships and write policies directly. Their business model has stayed relatively consistent following the transaction, as they now have the flexibility to underwrite business with CoverX then keep or cede out as much as they determine (providing an additional source of fees). FMR's IPO in 2006 was used to repurchase most of Glencoe's converted shares and pay down some high cost senior notes.

Their other main business segments by premium contribution include:

(1) Specialty Classes - underwrites smaller policies for various contractors (including roofing, plumbing, electrical, etc.). These have become an extension of CoverX products and are distributed through the same network of wholesale brokers. This group of lines has produced a large amount of overall growth premiums since it was started in 2000.

(2) FM Emerald - this line underwrites various property and casualty insurance, but the accounts have larger average premium sizes. The team joined FMR just over 2.5 years ago.

(3) AMC - writes then distributes policies to 3rd party insurance carriers on niche fuel-related business, and earns a fee for this service. It was acquired during February of 2008.

*It should be noted that 2008's results include a one-time gain on discontinued ops from the sale of AROCO. This created a one-time gain which boosted diluted EPS by $1.24 and makes total EPS look a bit smoother than if you were to strip it out.

The company's business model has usually been to selectively acquire specialty teams or businesses, and use their existing wholesaler and retail agency relationships to profitably grow written premiums. They've been able to average a combined ratio of 75% over the past seven years (range of 63% to 95%).

Present

First Mercury's underwriting discipline and growth in premium production have helped contribute to great performance, even when compared to other prominent property & casualty insurers. This is not meant to be a list of direct peers, as most of these companies are substantially larger (excluding Hallmark Financial). However, these are well run companies with good management teams, and long term growth in BVPS should be the ultimate goal of most insurers. Since FMR didn't IPO until late 2006, I've used a proforma book value for that year (previous years wouldn't be directly comparable due to extraordinary transactions).

Growth in Book Value (through 2009)

These results above are certainly a pat on the back for the management team, but what I'm more interested in is the price relative to value (and hopefully being able to buy at a substantial discount to intrinsic value). I've thrown together a handful of ratios to put each of these P&C insurers into a common size comparison chart. Relevant abbreviations are: IPS - investments per diluted share; BVPS - book value per diluted share; TBVPS - tangible BVPS, book value adjusted for goodwill and intangibles; P - share price.

The logic for this type of analysis is that when you buy the shares of a typical insurance company, the first thing you're getting is access to investment income from their investment portfolio (which would typically include any invested tangible equity plus float or "other people's money"). The more investments you can buy, the more favorable things would be at this step. In FMR's case, you are getting $4 of investment portfolio for each dollar you put in-in other words, each share has $43 in underlying investments. The other ratio that stands out is P/TBV. You're actually paying a 20% discount to tangible book in order to buy FMR's ability to grow BV at a faster pace than its peers. The next closest are HALL and HCC which are priced 43% and 59% higher respectively, based on this metric. Too high of IPS/TBV may be of concern especially with larger reinsurance exposure, but since each has a core of primary P&C operations, that's not quite as important here in my opinion.

What does the investment portfolio look like? Nothing too earth shattering with a weighted average rating of AA- and a taxable equivalent duration of 3.1 years. An interesting piece would be the 13.6% combined in convertibles and opportunistic-each seemed to be put on when there was a large pricing dislocation (and have made pretty decent gains). The opportunistic category includes a high yield convertibles fund as well as a hedge fund that invests in distressed non-agency MBS. I would expect their convertibles portfolio to have taken a solid hit during 2Q10, but that should more than be made up from the spread tightening within the rest of their bond portfolio.

And finally, this brings us to float. Warren Buffett loves float...and so do I. It's best when it comes at low or no cost to the insurer (combined ratio less than 100%). First Mercury has been able to grow float/sh at a 32% CAGR since the end of 2006, and they've managed to retain fairly solid underwriting discipline. Float per share has more than doubled over that period and you're paying less than half the price for it at the current price of $10.69.

Future

FMR recently announced at of July that they intend to acquire (in cash) Valiant Insurance Group from Ariel Holdings for tangible book value of approximately $55 million. Privately held Ariel has been rumored to be a potential acquisition target of Aspen (AHL) and in all likelihood is just trimming off the small subsidiary to make itself look like a cleaner prospective target. For FMR, this purchase will likely look similar to its past business combinations-the management team will merge any overlaps in lines, while adding a marine specialty line. From the press release, it looks FMR emphasizing Valiant's fee generation capabilities because they intend to cede all but 1/3 of the subsidiary's gross written premiums. It would therefore somewhat resemble their acquisition of AMC in 2/08, which was a tuck in acquisition that led their growth in "insurance services commissions and fees" earned from $0 in 2007 to $26M in 2009. Since the transaction is set to close in late in 4Q10, they are anticipating that it will have minimal impact on 2010 results, but be slightly accretive to earnings in 2011. A.M. Best and Moody's have both announced that they will maintain First Mercury's current A- and Ba2 ratings.

How much impact will this purchase have on FMR going forward? Aside from the fee revenues, they will also be retaining some of the policies. If we use the tangible book value of Valiant ($55M), and scale it up by FMR's ratio of (investments)/(tangible book value), this should approximate the company's eventual contribution to the asset side of the balance sheet. With FMR's ratio at 3:1, this would suggest that Valiant could possibly contribute an additional $165M ($9.49 per share) to the investment portfolio. This will likely be a gradual ramp up over a couple years, but even if one were to halve this estimate it would still contribute perhaps $4.75 to investments or 11% growth. With the combination of increased float along with incremental fee income, it's easy to see why they're projecting this to be accretive to earnings by next year.

All this previous information is interesting, but if the core business of underwriting is actually deteriorating then the prospective investment would be much less appealing. Glancing at the combined ratios over the past few years would seem to suggest exactly that--it started at 68% in 2006 and grew subsequently to 73%, 84%, and 95% in 2007, 2008, and 2009. In 1Q10, it actually hit 109% (this would be quite troubling viewed by itself) while EPS was cut in half in comparison to 1Q09. In fact, this may be the very reason why FMR's price-to-book has dropped from 1.0x to 0.65x over the last 2.5 years.

The first relevant factor for analyzing these results is related to industry conditions. Over the past 4 years, insurance underwriting standards have gotten less stringent, which naturally creates an upward pressure on combined ratios. As admitted carriers start to stretch their underwriting, it can have deleterious effects for First Mercury particularly because FMR's policies are so small compared to the admitted carriers capital bases. Secondly, the team saw deterioration in conditions of a legal liability line, which they recently phased out. And finally, FMR had a one-time pre-tax $5M restructuring charge which they anticipate will save them $4.5M annually going forward. This raised the stated combined ratio nearly 10% and also lowered diluted EPS by $0.22 assuming a 33% tax rate (1Q results would have otherwise been up slightly year-over-year at $0.52 vs $0.48). I would suggest that recent headline results have caused this neglected smallcap stock to continue getting overlooked despite its reasonable operational performance.

Valuation

I think this company is substantially undervalued using any reasonable forecasts of the future. The management team has recently put forward an estimated average 2011 ROE of 11.5%-12.5%; they most likely avoided an estimate for 2010 due to noise in prospective restructuring expenses and other activities. Normally, I would take these estimates with a grain of salt, but in this case they have been fairly close on their ROAE estimates over the past multiple years (not to mention they own a large chunk of s/o and likely wouldn't benefit too much from a shorter term pop in share price). They've even managed underpromise and overdeliver on target BVPS growth stated in their IPO prospectus.

For the purposes of this analysis, I am going to assume a two year holding period under three scenarios, with no benefit from any 2012 EPS. I've kept these projections fairly simplistic, but they should help to highlight the large margin of safety.

(1) Low - 6% return on average equity for 2009 and 2010, no stock repurchases, and decline in P/TBV from 0.79x to 0.6x; basically assumes no benefit from Valiant acquisition and reversion to 2008 operating income

(2) Base - 8% ROAE in 2010 and 10% for 2011, no share repurchases, and ending P/TBV of 1.0x; assumes minimal growth in premiums earned along with margins and combined ratios similar to 2009

(3) High - 10% ROAE for rest of 2010 and 12% for 2011, no repurchases, and ending P/BV of 1.0x; assumes small benefit from acquisition and recent restructuring

If the Low scenario were to play out, FMR would arguably become an excellent acquisition candidate over the next 2 years. Zenith National (ZNT) provides a good example of a specialty insurer that has seen combined ratios jump and EPS decline substantially since 2006. Their shares traded around tangible book during 2009 and early 2010, and Fairfax recently announced they will be acquiring ZNT at an approximate 30% premium to tangible book. I'm not saying this will be a similar situation here, but my point is that if FMR's stock price continues to trades lower (even with poor results) the company would make an attractive acquisition target based upon its large investment portfolio. Also, if the P/TBV were to simply stay constant at 0.79x, total return would be 31% (14.6% annualized). Let's not forget, this is for a company with fairly consistent generation of net operating profits and EPS.

There should even a bit more room for upside for the Base and High scenarios. I've assumed no share repurchases, although First Mercury is already authorization to buy back 5% of s/o, along with minimal benefit from the recent acquisition. Any repurchases would be highly accretive to BV, TBV, and EPS at these levels. Additionally, 2011 ROAE and EPS for the High scenario merely hit the mid-point of management's forecast (pre- acquisition announcement). Hopefully this set of projections seems somewhat conservative.

Risks

-The company decides to do a large capital raise and dilute shareholders at these low levels. I don't view this as very likely because management continues to own a large stake in the company. Additionally, FMR just paid a substantial special dividend, their management has stated they're comfortable with the current capital structure, and they will be doing the Valiant acquisition with cash.

-Competition from standard carries continues to increase, putting pressure on underwriting profits (and combined ratios). FMR would have to underwrite less profitable policies or scale back premium volume.

-A massive drop in equities negatively impacts their position in convertible bonds, while investment grade bonds fail to rally in price simultaneously. However, a flight to quality will likely not cause this response in the current market environment.

-Deterioration in underwriting quality occurs for FMR independent of the industry environment, and they start losing money on their core insurance business (I don't think the annual combined ratio has hit over 100% since at least 2001).

-Share repurchases under the current 1.0M share authorization

-Quarterly EPS normalizes along with combined ratios, as one-time events slow

-Acquisition of Valiant contributes positively to EPS in 2011, and adds to the existing investment portfolio

-Continued soft underwriting environment encourages a larger specialty insurer to roll up FMR into their operations--similar to recent acquisitions by Tower Group (OneBeacon), Fairfax (Zenith), and ProSight (Nymagic)