Description

Meadowbrook Insurance Group (MIG) is one of our favorite positions that we feel could appreciate well over 50% that has the following characteristics:

a)       Trades below liquidation value

b)       Not macro related

c)       Clear catalysts for upside performance and

d)       Multiple ways to play it through stock or convertibles.

This write up will focus on the equity, however we own the convertibles as well and consider them a bullet proof security with strong upside.

 Brief Description:

MIG is a specialty niche focused commercial insurance underwriter and insurance administration services company.  They compete in the specialty insurance market. They have agencies located in Michigan, California, Massachusetts, and Florida their main lines of business are workers compensation and commercial auto. The company has some reasonable presentations on their website which will help to provide some more background information.

During 2012 the company had a very tough year due to three main items:

1)       An increase in reserves in their auto liability program due to a new risk management technique which was poorly implemented

2)       Normalization of average case load per worker in CA  - basically they had written biz faster than they were able to train new people, case load had built up and claims started to flow through much faster : simply think of it as a backload of claims finally getting filed.

3)       Their Public Entity Excess program – They simply underestimated the volatility of this business line and it is our understanding they are planning on running it off.

So basically due to these above items the company basically kept adding reserves and kept missing earnings last year. They ended up cutting the dividend, stopping the share repurchase program and the main problem: A.M. Best put them on watch for a downgrade (which is a big deal in the insurance space)

We very much like the steps management has taken to right the ship and get back to creating value:

From the 10-k:

We experienced significant adverse loss development in the second and third quarters of 2012, announcing reserves strengthening of $28.2 million and $42.9 million, respectively. In October 2012, A.M. Best Company (“A.M. Best”) announced that it had put the financial strength rating and issuer credit rating of our Insurance Company Subsidiaries and our issuer credit rating under review with negative implications. The Company thereupon commenced a detailed review of potential capital enhancement strategies that could be taken to improve our capital position and maintain the current A.M. Best rating.  Steps taken thus far include:

On March 1, 2013, A.M. Best announced that they will maintain their ‘under review’ status with negative implications as they continue to evaluate the Company’s corrective actions.

                Honeybadger – After a few conversations with management, we have come to the conclusion that the company thought that these corrective actions would have been enough to get A.M. Best off their back, but no such luck which is where the next paragraph kicks in:

We are continuing to work with our advisors to explore other possible means of increasing our capital position.  Such means could include increasing borrowing, issuing debt or equity securities or entering into additional reinsurance arrangements. There can be no assurance, however, that even if we enter in one or more of these transactions to increase our capital position, A.M. Best will remove us or our Insurance Company Subsidiaries from review or that we or our Insurance Company Subsidiaries will ultimately not be downgraded.

Honeybadger- SO! The company issued a convertible bond and VOILA gets A.M. Best to remove them from the dreaded list. Now the stock was pounded, but has since rallied back on a) technical selling from convert abated, but also A.M. best removed the under review status and affirmed their A- Strength Rating. The convert that was issued is $100mm in size and is convertible @ 9.18. The hell you say! they just capped the equity! The company knows its stock is cheap, it knows @ 9.18 the stock is cheap, so they bought a call spread on the convert to push the EFFECTIVE conversion price to $11.69,that sounds a lot more like it! That is above our liquidation value and above book value. The company basically took out a combo bazooka (size) and sniper rifle (intelligent) to clean up the A.M. Best rating and did it in a way that was intelligent. The call spread costs money and clearly shows the company raised more than “just enough” capital. This is a nice signal from management. Further this was NOT part of the original plan and they viewed it as cheaper capital than the Swiss Re deal.

 We anticipate the swiss re-deal will be terminated at the end of this year providing an immediate jump of 15 cents a share which at even a 10x multiple adds an additional 20% to the stock.

We think management will be willing to discuss the removal of this contract in potentially the 3Q earnings call.

Finally Earnings. While we don’t pretend to be experts that can pierce through the fog of reserve reports, etc we feel management has set themselves up for underpromise/over deliver. The company went through last year adding to reserves on multiple occasions and having horrible quarter after horrible quarter. Finally Bob Cubbins and team said enough and as opposed to taking the traditional middle of a bell curve on risk “they were a bit more conservative so as to have no more surprises”. Theoretically that to me sounds like we are more likely to be in for reserve releases if anything in future quarters which should help to buoy earnings.

This is how the year went from a reserve standpoint Q1 – Add $10.2 million; Q2 – Add $28.2mm; Q3 add $42.9 (!) mm, Q4 add$ 4.2mm. In our opinion Q3 was the major bloodletting and things should start to get meaningfully better from here.

Further we think this is a reasonable/easy activist situation at some point. While insurance can be tough due to  its opaque nature, there are companies that have been bought out at fairly high multiples (but still discounts to book) by Enstar (ESGR, also known as Deathstar as they buy em and liquidate em) including the recent purchase of Seabright Holdings. There are no large shareholders with effective blocking positions, no insiders who own large stakes and assuming the above is correct, the company should be able to compound earnings if a battle were to become “protracted”.

Generally there are some positive comments out about some of MIG’s lines particularly its workers comp practice in California, but that is again, upside to the story as opposed to anything else of real consequence.

Valuation:

Let’s think briefly about what SHOULD be a floor value for the company assuming an additional $15mm in costs for the recently issued convert (high but there a call spread purchased so hopefully conservative):

Book Value ended the year @ 11.19 a share, intangibles equal about $150mm so TBV we will call it is about $7.90.

This in itself is a VERY conservative number as the right way to think about this is in a run off valuation and a sum of the parts. The company has approximately $425 million in statutory capital at the end of the year. Depending on your view on run off, assuming a three year average, and the company can earn a 3% yield on its assets backing those reserves that could add potentially another $100mm to the capital base. Further the company does have Earnings and fees from commissions which totaled a little north of $12 million in EBITDA. Using a reasonable 8.5x EBITDA for those cash fees provides approximately another $105 million in value above statutory capital plus earnings on run-offs (assuming estimates at this point are reasonable).

The main items left to remove are Wind down costs and debt. Lets assume $25mm in severance and wind down costs and between TRUPS and other small loans net cash there is ~$110m of net debt (again right now this assumes the converts are simply offset by the cash raised).

So $425 statutory + $100 earnings in wind-down + $85 in fee based earnings equals $12.25 a share, take out the $25mm + $110mm and that still leaves us with $ 9.85  a share. This excludes any value to the brand, current relationships/renewal rights and unearned premium. So we feel comfortable saying $10 a share is a reasonable run-off valuation and provides a fairly high margin of safety for any other potential risks in the underwriting.

Catalyst

General Catalysts:

Removal of Swiss-Re: Q3 earnings call we hope.

Share buybacks/Dividends – The company has in our opinion accelerated its ability to start buying back stock again, and in the past has had an active program. We think there is a real shot this is restarted in mid 2014.

Activist: trades below book, taxes nail their ROE pretty hard, management while generally seems ok, is just that “ok” and a strong book of biz in California workers comp could make this an attractive take out target.

HIGHER RATES! It is going to  happen eventually (I hope) and when it does the reinvestment off their bond portfolio will grow EPS. This is not specific to MIG.

The combination of underpromise/overdeliver, strong margin for safety and the lack of real “cyclical risk” with strong catalysts we think makes MIG a very attractive investment candidate that could lead to a 50% Plus move in the next 12 months.