Description

Overview

We believe Lancashire (LRE LN) represents an extraordinary risk reward opportunity, with 40-60% upside and only 5-10%  downside.    Trading at approximately 1.18x Q1 07 book value (1.11x Q2 07) and 4.7x 2007 Estimated EPS, the stock is very cheap on both an absolute basis and relative to its Lloyds and Bermuda comps.   In addition, the Company generates a high ROE (we estimate 27% for 2007), has a clean balance sheet, is very well run and writes significantly more insurance than reinsurance.   As a start-up in late 2005, the Company is positioned to significantly ramp up its earnings in 2007, and its P/B valuation should increase as well, offering the opportunity for both excellent book value growth and multiple expansion.  As a relatively young company, it is also under-followed, and we believe that analysts will pick up coverage over the course of the year.  Finally, given its mix of business, careful risk management and excellent pricing environment, we believe the Company could withstand a catastrophic event of unprecedented size and still make a profit for the year.

Lancashire is a Bermuda and London based property and casualty insurance and reinsurance company which was formed in December 2005 in response to the dramatic improvement in pricing, terms and conditions in most types of catastrophe exposed property business following hurricanes Katrina, Rita and Wilma.  Lancashire went public simultaneous with closing a round of private financing in December 2005.    The private financing was provided by a group of private equity and hedge fund financial services investors, including Och-Ziff, Moore Capital, SAB, Cypress (private equity) and Capital Z (private equity).   Successful insurance investing requires backing the right people, at the right time and for a good valuation. We believe that Lancashire has all three.

Management

Lancashire is run by Richard Brindle, who was the long-time deputy underwriter to John Charman at Lloyds from the mid 1980s to 1999.   Over that period, their average return was 17 percentage points better than the market, and they never had a losing year.   Their business (“Tarquin”) was backed in 1994 by the predecessor fund to Capital Z and was sold to Ace in 1998 for a gain of approximately 5x.   Capital Z obviously knew Brindle quite well from these days and their involvement in Lancashire stems from this.  Both Brindle and Charman soon left Ace.  Both resurfaced following 9/11.  Charman founded Axis, which has generated the best ROE of the Bermuda “Class of 2001” (19%, versus the next best, ACGL, at 17%, after which it drops dramatically).  Brindle resurfaced at AIG’s Lloyds business.    You will find that Brindle is not your average insurance executive.  In addition to having a great track record and having learned the business from the best person in the business, he is young, very smart, savvy and tough operator. 

Business

Lancashire writes a diversified book of property business.  Unlike most companies in Bermuda, however, Lancashire writes mostly insurance (70%) (versus reinsurance) and does not write any property catastrophe reinsurance.  Although Lancashire does take on natural catastrophe exposure, it does so by writing retro (insurance for reinsurers) (18% of gross premium written in 2006) and offshore energy risks (oil rigs, etc) (27% of gross premium written) and a certain amount of direct commercial insurance risks.  The Company believes that rates, terms and conditions (and expected returns) in its targeted lines are even higher than in traditional property catastrophe reinsurance.    In certain lines of businesses, pricing was up over 10x in 2006.  While some of this was due to the insurance industry’s (and world’s) view of the increased frequency and severity of hurricanes, expected returns have also improved significantly.   With a primary office in London, Lancashire’s mix of the Company’s business is similar to what would traditionally have been written in Lloyds (terror, marine, energy, aviation, political risk, etc), but with the “modern” risk analysis and underwriting techniques generally employed in Bermuda, creating what we believe is a “best of both worlds” company.

Valuation

We believe that book value multiples are the most appropriate method for valuing property and casualty insurance companies (except for, arguably, a handful of personal lines carriers).   Trading at approximately 1.25x of trailing (12/06) tangible book value per share (1.18x Estimated Q1 07 and 1.00x Estimated Q4 07), we believe that Lancashire is a compelling value opportunity on both an absolute and relative basis.   We believe that LRE will earn 25% - 30% ROE in 2007, making its BV valuation that much more attractive.  Its London market peers trade at 1.40x - 2.20x tangible book value per share with an expected average 2007 ROE of 20%.  While we believe that the London companies are the more appropriate comps for a variety of reasons, it’s also worth noting that LRE trades at a discount to the most comparable Bermuda companies (1.20x – 1.60x) (18% average expected ROE).   As a relatively new entrant, Lancashire also obviously benefits from having a clean balance sheet (no exposure to asbestos, environmental or the catastrophic casualty years of 1998 – 2002).   Book value per share growth will be somewhat less than book value growth due to management and founding investor warrants (similar to AXS experience).  We estimate that this will impact BV/share growth by 2-3% points in high ROE scenarios (less so in lower ROE scenarios).

Lancashire is equally compelling on an earnings yield/PE basis, trading at only 4.6x 2007 EPS (our estimate = $1.50 = 27% ROE (beginning of year BV)).   A number of people seem to have missed how earnings for this company will ramp up.   In its first year of operations, Lancashire earned a 17% return on equity ($0.79 EPS).   However, earnings were artificially depressed as only 45% of its premium written was earned in 2006 (the remainder will be earned in 2007, along with a similar portion of the business written in 2007, creating a “fully ramped” earned premium base) (this is characteristic of an insurance company’s first year of operations).  Had its $302 million of unearned premium been earned in 2006, Lancashire’s return on equity would have been 41% ($1.89 EPS).  The Company is not widely followed.  Only 2 estimates appear on Bloomberg, and they do not make much sense  ($0.66, versus $0.79 last year and our estimate of $1.50).  Merrill has a $1.11 estimate which is more reasonable but does not show up on Bloomberg for some reason.

There will be positive and negative impacts on 2007 earnings, including:

·          Positive.  Dramatic growth in premium earned (the “fully ramped” aspect discussed above).  This is by far the primary driver of earnings growth in 2007.

·          Negative.  2006 was a very favorable year for losses, and, on a mean basis, 2007 will not be as good a priori.   There were very few insured natural catastrophes and limited losses in the Company’s other lines of business.  The company booked a 19% net loss ratio last year.  Although it is somewhat hard to imagine that results were actually better than that, 97% of the Company’s reserves at year-end were IBNR (incurred but not reported), which strikes us as conservative given the very short tail nature of the Company’s business.  Hence, we believe the actual loss ratio will prove to be better than this, and we would not be surprised to see reserve releases in 2007 (although our numbers do not assume this).  We are using a 37% accident year net loss ratio this year, which we believe approximates the stochastically modeled loss ratio for these businesses (ie, the average from running thousands of scenarios).

·          Negative.  Pricing is coming down somewhat in certain of the Company’s lines of business.  While a negative, we believe conditions are still very attractive.  If one starts at a 30% expected loss ratio (where we believe 2006 business was written), a 10% rate cuts results in an expected loss ratio of 33%, still very attractive.

·          Positive.  Growth in premium written.  Lancashire added people over the course of the year last year, and several of its underwriting teams only ramped up towards the end of last year.

·          Positive.  Greater investment income due to higher rates and greater “float” (although float for a property company will always be more limited).

The Company has guided to 20-25% ROE in 2007, which we believe is conservative.  Moreover, “median” results (average loss ratio is much higher due to the impact of big catastrophes) would be much higher (closer to the 41% cited above).

Our Q1 07 BV number assumes the same “mean” loss ratio which we are using for the full year, but, given that the quarter seems like it was very benign (now that loss estimates for Kyril have come down substantially), actual results could be significantly better.

Risk Management

The Company limits the amount it can lose from a “1 in 100 year event” to under 25% of capital.   Given the Company’s expected returns for the year (which include a significant cat load) and the fact that the 1% probability US event is now estimated to be $103 billion dollar event (versus Katrina, the largest cat ever in dollar losses, at approximately $50 billion), we believe the Company could withstand an unprecedented loss event and actually make a profit for the year.   The Company estimates that a repeat of 2005’s “KRW” (Katrina, Rita, Wilma) would result in net losses of approximately 20% of book value, also resulting in a profit for the year.

Trading Note

The stock trades in GBP on the Aim in London.  However, its financials, all of its capital and much of its business is conducted in USD (US Dollars).   Hence, the stock price tends to (and should) move based on the exchange rate.  Ie, if the GBP strengthens against the dollar, the stock price in GBP will generally fall (as the value of the Company’s book value, denominated in USD, has declined).  However, the value to the US holder has not changed (drop in stock offset by appreciation in pound).  Make sure that you do not instinctively hedge out the currency.   This caught many investors off guard last spring when the GBP jumped from 1.75 to 1.90x against the USD.

Risks

Cats: While we believe that Company can handle an event of unprecedented proportions and still actually turn a profit for the year, a series of very large storms ($20 billion plus) that hit Florida and the Gulf could be problematic for the Company (although still unlikely to be catastrophic).

Pricing: While the fall off from last year’s peak rates seems to be fairly measured thus far (and some lines are holding up very well), there is always the probability that this accelerates.  We believe this is unlikely, but, should it occur, we believe there are two primary mitigating factors.  First, management has a history of being very disciplined and we don’t think they will write unprofitable business.  As they do not have extensive overhead, they could afford to cut business without creating an expense problem.  Secondly, at this valuation, we believe there is little downside.

Price Target

We believe that the stock could have 38% - 65% 12 month upside (25% - 30% ROE with 1.30x BV - 1.50x BV multiple).  We do not think that the Company gets to the high end of the range of comparable London companies, as the companies at the high end of the range generally have the higher operating leverage (premium/capital) which Lloyds allows.   We also believe that the downside is very limited due to: 1) the low valuation (less than year-end book value), 2) very good competitive environment (while prices are in fact falling in many lines of business, they are falling from such attractive levels that expected ROEs should still be very good, as illustrated above) and 3) prudent risk management.  

Catalysts

While this is primarily a long/intermediate term story of a good business at a tremendous price, we believe there are several potential catalysts.

The first is the earnings ramp up of the Company.  We believe that many people see Lancashire as a 17% ROE company rather than a 25-30% ROE Company, and as earnings emerge over the year, we believe that the Company will be re-rated.  As a starting point, the Company releases earnings Tuesday.  We are forecasting $0.34 for Q1, which may be conservative (reality was more of a “median” quarter of losses rather than the “mean” we are using, and there may be some reserve releases from 2006).   In any event, this number will compare very favorably to the Bloomberg estimate for the year of $0.66.   Neither Bloomberg nor Merrill have a quarterly estimate.   (As another example of trying to be “best of both Londan and Bermuda insurance worlds”, Lancashire is breaking with London tradition and actually going to report on a quarterly, vs. semi-annual, basis).     

Secondly, one of the things which has hurt the stock is that management has been largely inaccessible to many investors.  However, management is hosting its first US investor day this week, hosting meetings in Boston and New York, which we hope reflects a new approach to investor relations.  We believe the exposure and accessibility could have a very positive impact on the stock.

Third, another factor which has hurt the stock in its first 16 months is the fact that the Company “missed” its premium projections in 2006.  Unlike what one would see in the US, LRE included projections in the IPO prospectus which included top line forecasts.   As anyone who has been involved in a start-up knows, initial business plan projections are somewhat subjective, to say the least.  Our view is that by writing $626 million of written premium, 70% of which was insurance (harder to write than reinsurance), and generating a 41% underwriting year ROE, the Company had a pretty unbelievable first year of operations.   As we move away from the start-up business plan and people start to focus on the earnings power of this Company, we believe a negative misperception will be removed.

Finally, while very thinly covered by the sell side today, we believe that he will pick up favorable coverage from an additional 1 or 2 of the UK analysts this year.

Catalyst