Description
Mercer is a 161 year old regional insurance business that demutualized just 15 months ago, gaining an excessive infusion of capital that it has utilized to buy back stock between 75% and 82% of tangible book.
This post-IPO slug of cash has dramatically decreased its ROE to just 3%. Most insurance companies employ borrowings, never mind lugging around excess cash.
David101 gave MIGP an excellent writeup last year, and it is worth reviewing:
http://www.valueinvestorsclub.com/value2/members/view-thread.asp?id=1366&more=dtrue. Incredibly enough, the stock is actually a bit cheaper, despite the story being much better from a margin-of-safety point-of-view, and management’s capital allocation approach being given the test of time.
Mercer’s combined ratio has been phenomenal. The company’s 2004 combined ratio was a very good 98.8%, but not remarkable compared to their stunning five year track record prior to going public, which had combined ratios all below 95% (ranging between 92.7% and 94.8%).
An insurance company with superior underwriting results should trade at a premium to its peers, and I suppose it eventually will once Mercer diminishes its excess capital, but let’s stop here and make a base case for value:
For the stock to rally to book value would represent a 28% increase. Plus, add an annualized 3% in earnings and 2% in buybacks. If it happens in 2 or 3 years, IRR should be in the mid to high teens.
Buying back stock has been a no-brainer and sets the bar that much higher against any acquisitions they might contemplate, which is comforting since its peer group trades at a premium, averaging near 120% PB but up to considerably higher.
Mercer has a small business orientation, aiming to insure “Main Street” type of accounts, as these businesses generally incur fewer casualty claims, given that people are less inclined to sue familiar neighborhood establishments. They underwrite in PA (25%) and NJ (75%), and they combine personal lines with their much more profitable commercial lines, as neighborhood insurance agents are likely to want to use the same carrier to insure a mix of both homes and businesses. Mercer is trying to shift the mix from 60% commercial lines to 80%, since these lines have recent historical (1998-2003) average combined ratios of a 91.0% combined ratio (versus 101.8% for the personal lines). They do have a relatively high expense ratio—part of which is good, as it reflects incentivized commissions based on underwriting results, and some of which will go away now that they no longer face retaliatory premium taxes and other arcana that was unique to their pre-IPO structure.
No longer capital constrained nor draining profit to outside vendors, Mercer’s terrific business just might have some growth legs, and an investor gets a very compelling value today as Mercer runs the buyback playbook while you own one of the best regional insurance businesses in the country.
That’s the quick version. Now, all that being said, it makes sense to drill down and examine everything a bit more closely. Please be patient with the repetition as I take the overview above and flesh out the details.
The process of demutualizing was long and drawn out. Along the way, another insurance company offered to essentially take over Mercer’s operations—sort of along the lines of “If you’re going to try this manuever and leave the mutual world, we’re going to make it very, very difficult.” That delayed their IPO by many years—they have S-1’s going back to December, 1997, and constrained operations.
Being constrained, Mercer had to run its operations in a manner that maximized its capital to serve its core policy writing. Therefore, it utilized an outside service bureau to process its policies. Part of the IPO (which netted $54M) was used to complete the transaction for another insurance company which had a headstart on the processing side (Franklin Insurance received $5M in shares), while an additional $4.1M has been/will be used to build out that platform. It is anticipated to be completed in mid 2006. The resulting savings will be about $700,000 per year, and will give Mercer an obvious opportunity to grow (either organically or via acquisition) while getting better economies of scale on its expense ratio. It wouldn’t surprise me if the completion of this platform coincided with acquiring another small insurer whose operations would immediately benefit from Mercer’s build out.
Mercer also had been paying retaliatory taxes that should no longer apply and perhaps may even be recovered on appeal ($2.4M). This is complex, but in a demutualization, existing policy holders get rights to purchase the stock, but Mercer had a combined mutual (PA) and stock (NJ) structure, and so had to contort itself to get through the process and preserve those share rights. I don’t expect anything on appeal, but then I wouldn’t discount it either, as MIGP definitely represents a unique situation. The primary benefit is going forward—saving on the retaliatory tax is another $600,000 per year. The combined savings from the processing and the retaliatory tax brings another $0.20 to the bottom line each year.
Again, post IPO, Mercer has been able to raise its reinsurance ceiling and meet some pent-up organic growth. It has grown premiums nicely over the last year, with 2004 premium growth of +17%.
So, there are two aspects to this story—there is the business and there is the stock. The stock is essentially an insurance company with a giant money market attached to it, but there is a lot of compelling stuff going on via the buybacks. Simply put, $100M in equity against $180M in assets is too much equity.
Mercer has announced and completed two buybacks of 250,000 shares. At $12.99, using my estimated book value of $16.63 and tangible book value of $15.85, Mercer is currently trading at 82 % of tangible book and 78% of book value. Each 250,000 share buyback represents approximately 4% of outstanding shares.
It is easy to see why this stock has been relatively ignored. While it is trading below tangible book value, its ROE was just 3% in 2004. This is well below its historical ROE, and it isn’t necessary to assume great ROE’s going forward to see the value here. Let’s get back to that base case for valuation.
There are two proactive ways that Mercer can diminish this cash hoard that is cramping ROE. The first is obviously through an acquisition. Seeing how they are patiently building out their platform, growing organically, optimizing reinsurance needs, and buying back stock, I’m willing to give Andy Speaker, the CEO, more than the benefit of the doubt that an acquisition will be at least comparable to buying back stock at these levels. He seems very level headed, and his operational goals emphasize running a combined ratio of 95% while maintaining the current bland (low risk) investment portfolio. He also mentioned that all of the employees are completely focused on operations, and informed me that he would be the only one who might divert any energy to exploring possible acquisitions.
He did agree with my assessment that buying back their own stock has been a far more favorable purchase than any realistic alternative acquisitions. The CEO is young (okay, around my age), has been with Mercer for fifteen years, and became familiar with them as their CPA. He has been their treasurer, CFO, COO, and for the last five years, their CEO. I believe that his interests and incentives are firmly aligned with long term oriented shareholders.
The second proactive way is through buybacks, but there is an additional twist. After MIGP finishes running the buyback playbook, they have lots of room to run the dividend playbook. Obviously, while the stock can be purchased below tangible book, buybacks remain the best option, but the 10K brings up an interesting option. According to the 10K, MIGP can’t pay dividends for three years after conversion without special permission from PA and NJ. They do subsequently mention that they could pay out as much as 10% of the statuatory surplus annually. The amounts mentioned as available would be $6.2M (from PA) plus $1.6M (from NJ) plus $0.6M (from Franklin) in 2005 if these dividend restrictions weren’t in place. Obviously, I don’t expect a 12% dividend yield, but it does illustrate their options.
In effect, this gives Mercer the option of continuing to buy back its cash for eighty cents on the dollar for the next year or so, and then if it does go to a premium value, they can return those dollars via dividends if they so desire a leaner capital structure at that point. I do find it ironic that while we might never expect to see a business like this valued simultaneously at a significant discount to tangible book and with a meaningfully attractive dividend yield, it isn’t a stretch to see this stock being dominated sequentially by these characteristics over the next three years.
Now, let’s move on to earnings. What’s the story here? A line in the 10K says it all, from 2002 to 2004, the return on average cash and invested assets has been 2.7%, 2.0%, and 2.0% respectively. The investment portfolio is dominated by low risk bonds (Govt and AAA makes up the majority). Mercer historically made all of its money on the underwriting side.
The GAAP combined ratio has been:
2004: 98.8%
2003: 103.8%
2002: 96.4%
2001: 93.6%
2000: 93.2%
1999: 92.4%
1998: 96.1%
Last year, they made $0.51 with a combined ratio of 98.8%. On net earned premiums of $55.8M, reducing the combined ratio in line with their historical results would add an additional $0.33 to earnings.
Despite a return on average cash and invested assets of just 2.0% last year, this was responsible for $0.44 in earnings. With rates generally higher this year, an additional 100 bps would add $0.22 in gross income. They have now hired a new management firm to manage its fixed income securities portfolio, and as of 12/31/04, the portfolio had an average rating of AAA, duration of 3.7 years, and average tax equivalent yield of 4.17%.
Putting it all together, a good underwriting year can easily see MIGP’s earnings more than double.
Where’s the room for improvement? The current management has reoriented the company over the last seven years from being dominated by personal lines to being commercial oriented. The personal lines results have recently been heavily dominated by the impact of winter storms and other weather related damage, and it’s been ugly the last several years, with combined ratios of 121.0% (2004), 122.6%, (2003), and 107.0% (2002). Despite the atrocious personal lines last year, Mercer still had a 98.8% overall combined ratio.
On the other hand, the combined ratios for the commercial lines segment, which represented 62% of direct premiums written last year, were:
2004: 82.8%
2003: 88.1%
2002: 85.6%
2001: 90.4%
2000: 82.9%
A string of mild winters could deliver stunning results for Mercer, and would be icing on the cake. Of course, simply being able to purchase their stock significantly below book value, optimizing their business without capital restraints (there are S-1’s going back to 1998…it’s been a long road), and continuing to operate an impressive underwriting book makes for a compelling value story.
Catalyst
Significant discount to tangible book value.
Lots of room for financial engineering via continued buybacks and eventually potentially significant dividends.
Underwriting prowess masked by recent tough winters.