Description

I was going to post PRI at $13/shr this morning as an April's Fool's joke, but figured that wouldn't be funny to those like me who wasted time on it only to see it become a hot deal. Instead, I've got a different insurance company that may not be as interesting as PRI at $13, but hopefully is better than PRI at $20 (although if you love PRI at $20, I mean no disrespect!)

MHLD is a Bermuda-based specialty reinsurance company. The firm provides reinsurance products and services to U.S. and European insurance companies that specialize in coverage at low limits, or risks that are low hazard, predictable, and not susceptible to catastrophe claims. The company was formed in June 2007 by the management and founders of Amtrust Financial ("AFSI"), a successful specialty insurer.

AFSI primarily underwrites coverage in three market segments: small-business worker's comp, specialty risk and extended warranty, and specialty middle-market P&C. AFSI has been very successful in recent years by focusing on niche insurance markets that are reasonably predictable, and where the company has structural cost advantages. For example, in AFSI's small-business worker's comp business it is underwriting extremely small businesses (e.g. a restaurant) where getting processing cost down is the key and where the company is often competing against the State fund. The company's specialty risk and warranty business wouldn't be likely to write warranties for a TV sold through Best Buy, but might write warranties at a local store like J&R.

The investment is interesting because it offers a way to participate in high return insurance products at a very low valuation. Many Bermuda reinsurance companies trade at low multiples of book value and earnings, and they probably should given the volatility of earnings and only modest barriers to entry. Furthermore, "start-up" insurance companies also trade at low multiples of book value, and they probably should given near-term losses and a long timeline to get to targeted returns. However, we believe MHLD offers an opportunity to generate structurally attractive long-term ROEs with reasonable current profitability and a pathway to achieving targeted returns over the next few years.

As the "anchor client" AFSI has signed a long-term quota share agreement whereby it cedes 40% of its written premium on most product lines to MHLD. The economics are such that AFSI benefits by generating non-capital intensive "fee income" through a commission paid by MHLD that is higher than AFSI's cost to originate. MHLD benefits by gaining access to AFSI's high return business at a reasonable commission. The ecosystem benefits by enabling AFSI's distribution to grow and scale faster than it otherwise would and allowing a significant amount of the earnings to be generated at the MHLD level, where as a Bermuda-based reinsurance company it pays little income tax.

However, while AFSI was instrumental in launching the company, MHLD's strategy is broader.  The firm seeks to capitalize on a gap in the marketplace that exists for reinsuring small specialty insurers on a frequency basis.  Management believes there are many subscale insurance businesses that would benefit from a well capitalized partner, but who are not large enough to generate interest from the major reinsurers.  MHLD can offer long-term quota-share agreements whereby its clients can improve ROEs by scaling more business (and generating fee income) over a relatively fixed cost structure.  MHLD effectively has access to moderately priced "distribution" and then does its "earning" in a low tax jurisdiction.  Importantly, MHLD is not taking catastrophe risk, but is effectively sitting side by side with its client-insurers writing lots of small risks that are reasonably predictable (e.g. frequency vs. severity).

In late 2008 the company announced that it was acquiring the reinsurance operations of GMAC.  The positive is that this accelerated the company's non-AFSI growth plans at an attractive price, as buying anything from GMAC in late 2008 is likely to be a good deal.  The negative is that GMAC Re was a very large transaction relative to the size of MHLD and there were concerns about the potential "death spiral rights offering" that would be needed to finance the deal.  In the end, the company did a $260MM 14% trust preferred offering (the Karfunkels backstopped it and took down 60%), which came with partial stock coverage.  It was an expensive deal, but that was the market at the time.  The securities are callable at par anytime after January 2014 and at 114 until then.  The stock subsequently recovered from "death spiral" prices, but it has been stuck since the summer despite (or because of?) generally strong equity markets.  Accordingly, we think the risk/reward is now very attractive.

Management & Founders

The Karfunkels have been very successful real estate investors and entrepreneurs.  They are probably most well known for their involvement in American Stock Transfer.  They founded the company in 1970 and sold it in May 2008 for $1 billion to an Australian private equity group.  They created AFSI over the last dozen years through opportunistic acquisitions and renewal rights transactions.  AFSI was built to be a low cost model that could attack underserved markets that were subscale for major carriers.

There was a short write-up posted on AFSI a couple of months ago.  While I'm happy to discuss any specific issues, it's probably not worth going through line by line.  The key thrust seemed to be that AFSI is a family controlled company, and that this is bad.  MHLD and AFSI are family controlled, but we think this is a good thing.  When it comes to insurance companies, I am a huge fan of investing in owner/operator controlled firms - especially ones with a track record of success.  Insurance is a business that allows management to a) Write their own report card for a while and b) Do very stupid things at points in the cycle that can be extremely destructive.  We think management teams who own the downside as well as the upside (in contrast to managers paid with stock options or bonuses) add a lot of value over the cycle.  In addition to MHLD, we own a couple of other owner/operator controlled firms for reasons in part related to this concept.

Being a family controlled company, there are several related parties.  Michael Karfunkel is the Chairman of AFSI.  Barry Zyskind, his son-in-law, is the CEO of AFSI and the Chairman of MHLD.  The family own approximately 60% of AFSI and just over 25% of MHLD (there are some restrictions on US person ownership of a Bermuda base firm).  The family also owns 4MM warrants struck at $10/share and $160MM of the trust preferred stock that was previously referenced.

MHLD's senior management comes predominantly from GMAC Re.  Art Raschbaum, CEO, was the head of GMAC Insurance and had been with the company for over 30 years.  John Marshaleck, CFO, had been with the company for about 25 years.  It is not only the Karfunkels who seem enthusiastic about the prospects of the business.  If you use the insider transactions function on Bloomberg ("CN WSA") you will consistent insider buying that is unlike 99% of companies I am aware of.

MHLD should continue to benefit from opportunistic activity by its founders and mangers.  In October 2009, the Karfunkels acquired the consumer primary P&C businesses of GMAC through American Capital Acquisition Corp. ("ACAC").  In March 2010, MHLD signed a quota share reinsurance agreement for 25% of this $1 billion business.  This is clearly a large tailwind relative to MHLD's existing $1 billion of annual written premium and helps allow MHLD to both grow and maintain discipline in a soft reinsurance market.

Valuation & Earnings

At 12/31/09 book value per share was $9.62 and TBV/share was $8.15.  The company has approximately $100MM of intangibles associated with the acquisition of GMAC Re.  The company had operating EPS of $0.93 and an ROE of 10.9%.  This is slightly overstated because the capital raise did not close until part way through 1Q09, but it is approximately right.  This puts the stock at 0.8x BV, 0.9x TBV, and 8x TTM EPS.  The stock has a 3.5% dividend yield. 

The company's earnings growth has been limited over the past year or so by low interest rates, and to a lesser degree a competitive P&C market.  That said, we believe that the company can drive above average earnings growth by investing its growing capital base and moderately improving ROE.

There are several puts and takes on ROE as we look out into the future:

Tailwinds:

• The company has been very conservative about investing its assets.  The company has short durations, a higher than average mix of cash and floating rate securities, and little credit risk.  To the extent rates rise in 2011-12, the company should benefit.
• The company is modestly overcapitalized relative to the level of policies in force.

Headwinds:

• The company's capital base has grown a lot over the past 12 months as asset prices rebounded.  This is causing ROE to expand in 2010 less than it otherwise would have.
• The reinsurance and broader P&C market continues to be soft (at least outside of catastrophe coverage).

We estimate an ROE of approximately 12% in 2010, getting to EPS of $1.15.  We believe that the company's ROE can expand to 14-15% over the next couple years, getting to approximately $1.60-1.70 of EPS by 2012.  We don't expect ROE to go much higher than this, but growth should continue to be better than peers because of the company's exposure to AFSI.  At 6-7x EPS and 0.8-0.9x book value, with a relatively clean balance sheet we see limited downside.  We think the upside is getting 8-10x $1.60 in a couple of years, or approximately a double in the stock.  As a sanity check, this would translate into under 1.3x book - not outrageous given what will still be a good growth and ROE profile.

Catalyst

• The company hits 2010 earnings estimates and starts to get re-rated from a "below average" re-insurance company to an "above average" re-insurance company.
• Interest rates start to rise.
• P&C market starts to harden and stocks improve from trough valuations.