Description

Hallmark is a small, well managed specialty insurance company that trades at roughly 75% of GAAP book value and right around tangible book value.  A quick look at a historical financial table shows a strong history of book value per share growth prior to the financial crisis ($4.52 per share to $11.26 from 2003 to 2009), and then basically a couple years of treading water ($11.26 to $11.45 from 2009 to 2012) followed by recent improvement ($11.45 from year-end 2012 to $13.62 as of Q3 2015).  The recent stock price was right at $10, or right around 75% of stated book value. 

Please note that HALL is not super-liquid (trading volume about 55K shares per day) and has a market cap of less than $200M, so probably only worth a look for private investors and smaller institutions that fish in smaller cap names.

Hallmark was written up on VIC back in November 2009 by trev62, when the stock traded for about 70% of book value (and a stock price of $7.44), and I recommend a brief review of that write-up as it offers a good portrait of the business as it existed at that time.  It was also a decent time to buy the stock. I also encourage interested investors to pull down the most recent HALL investor presentations:

http://www.hallmarkgrp.com/index.php/page/index/presentations

The company is managed by a strong team in the classic owner/operator model. Current Chairman Mark Schwarz previously also served as CEO prior to 2006; since then he’s been Chairman of HALL.  Schwarz wears a lot of hats – he serves as the control investor of Newcastle Partners, a PE and formerly also a hedge fund firm, and is also currently the Chairman of Rave Restaurant Group (RAVE) (formerly known as Pizza Inn) and Wilhelmina International (WHLM), a model management and talent representation company.  He has also been a director of several other publicly traded companies.  Newcastle owns about 25% of the outstanding shares of HALL.  

Schwarz initially invested in Hallmark in 2000 when the company was a single-line insurance business, and has built the company through selected acquisitions of specialty operations.  HALL acquired a standard P&C insurance agency in 2002, a non-standard auto insurer in 2003, another specialty agency and aviation underwriting business in 2006, and acquired four more small insurers from 2008 to 2011.  As a result, today HALL is a very diverse company with different business units, despite its small size, with roughly 70% of its business in “niche” specialty markets where HALL has a strong market position.

HALL’s business is to focus on under-served short-tail lines of insurance with low severity and high frequency.  The company writes about $475M in premium per year, and cedes about ¼ of that risk to reinsurance partners. In 2014, specialty commercial accounted for 68% of gross written premiums (of which a good chunk of this is specialty commercial auto) while standard commercial accounted for 18% and personal lines 14%. Texas represents about 50% of total premiums produced. 

Unfortunately, after many years of outstanding underwriting results and combined ratios in the high 80s, from 2010 to 2013 HALL suffered a four year period of somewhat poor underwriting results (102% combined ratios in every year but 2011, when it was 112%) due to adverse results from its personal auto business in Florida (which the company has now mostly exited) and losses in some of its standard commercial lines due to some very costly storms in Texas during those years.  HALL responded by increasing rates where appropriate, and achieved 7% YOY rate increases in 2012, 8% in 2013, and 4% in 2014.  The company also largely exited the personal auto business and streamlined its product offerings substantially.  As a result, recent performance has been better as in 2014 the company returned to an underwriting profit with a 96% combined ratio. Through the first nine months of 2015, the combined ratio was 93.4%.  

I will mention the investment portfolio briefly, because it is quite big relative to HALL’s market cap.  HALL has a $660M investment portfolio.  As of March 2015, credit investments comprised $450M (of which about $131M was in tax-exempt securities), equities were $56M, and cash and equivalents were $143M.  This comes out to about $35 per HALL share.  HALL’s investor presentation states that they consider investing to be a core competency, and describes their approach as “disciplined and value-based.”  The company has shown some skill on the investing side over the years (and review of trev62’s write-up can provide some more background here), so I expect that HALL will at least be no worse than average on the investing side going forward.  But of course it bears mentioning that we are long a big, fixed-income weighted investment portfolio here. 

In mid-2014 HALL announced that it had replaced its long-time CEO Mark Morrison with Naveen Anand.   Anand built what is probably a good comparison to HALL at Torus, where he ran the US business from a start-up in 2009 to $250M in gross premiums written over five years across six specialty lines.  Torus was acquired by Enstar in 2013 for $692M (note that this acquisition price was for all of Torus, not just the US business).  Prior to that, Anand was at CNA (owned by Loews) where he was responsible for the commercial business lines, and before that at Chubb.  What is most interesting is that Morrison actually stayed with the company as a Senior VP.  This doesn’t happen often and I think it says something interesting about HALL as a company.  Given the significant insider ownership, HALL has most of the earmarks of a company run for the benefit of shareholders.  Executive compensation is modest, with the top execs in 2014 earning about $1.5M in aggregate cash compensation. HALL appears to set all the internal incentives correctly; underwriters are paid on underwriting profit, not volume, for example. The company also did buy back about 8.1% of the shares outstanding from late 2009 to mid-2013, at an average price of $7.17 per share.  The company bought back a tiny bit of stock in Q3 2015 at prices below $11.50.  Shares outstanding have fallen over time from 21 million in 2007 to 19.2 million as of Q3 2015.

Let me now address a couple of the potential weaknesses / risks to the thesis.  The first is that while the company’s long term track record is decent, a loss triangle analysis shows that they haven’t been particularly conservative in their loss estimates, and there have been cumulative loss deficiencies (most of them modest) for 7 of the past 10 underwriting years between 2004 and 2014.  I believe the company’s efforts to enter and expand into the Florida personal auto business was the biggest contributor to this, but it is still something HALL needs to put behind it pretty definitively.  Also, the Texas concentration means that HALL has been heavily exposed to several record storm events in the past couple of years that did not impact more geographically diverse businesses nearly as much.  Texas gets some freaky weather events, and even though it is a big state (about the size of France) it could still be considered high geographic concentration.   

As for an update on recent events, in the first nine months of 2015 HALL has shown continued improvement in its underwriting operations.  GWP was $390.7M versus $363.2M in the nine month period of 2014, and NWP was $263.5M vs. $237.7M.  Net income was $18.4M versus $9.7M, so almost a double from the year prior.  EPS was 95 cents versus 50 cents.  Operating cash flow is also up to $43M versus $22M. I’m not sure this is anything super meaningful, but it does reflect rising premiums.  The company noted that it pushed for and received rate increases in all of its segments in the last year, although the trend is likely to weaken beyond 2015.  Combined ratios were 91.0% in Q3 2015 and 93.4% in the nine month period, both strong improvements over the prior year and now well back into strong performance figures.  The company has also reported favorable claims development of $4.6M in 2015 versus a $1.5M unfavorable adjustment last year, which is a good sign as it relates to addressing the prior stretch of under-reserving.  BVPS was $13.62 as of the end of Q3 2015.

Given HALL’s diversified book of specialty insurance companies that have generated pretty reliable underwriting profits over most of its history, I find the current price of less than 75% of stated BV and a slight discount to tangible BV to be clearly undervalued versus what HALL would be worth on the private market to a larger acquirer.  Profitable specialty insurance companies often go for 25-50% premiums to book value.  I also think that there is an off-chance that Chairman Mark Schwarz is actually an above-average capital allocator, and that current CEO Naveen Anand is an above average operator.  The biggest negative is of course HALL’s very limited liquidity (average daily trading volume is about 50K, but there are many days when HALL trades only 25-30K per day). While maybe not the most exciting pitch, this is a company that has tripled BVPS from 2003 to 2015, which is a decent accomplishment, particularly given the relatively difficult period HALL encountered that cost them a couple of years’ of compounding.  We have it sized modestly as part of a basket of small cap financial stocks that we think are possible acquisition candidates and / or decent BVPS compounders. 

Catalyst

  Acquisition by a larger insurance company at a nice premium to BVPS

·        More aggressive share repurchases

·        Capital return (i.e., special dividend)

·        HALL has been a good acquirer in the past; they could do more smart deals and compound away