Description
Mercer Insurance Group is a small P&C insurer (market cap just under $100 MM) that demutualized last month, and represents an attractive buy based on its book value relative to peers and its earnings potential without any taint of asbestos. Mercer is an A.M. Best “A” rated insurer with no debt that currently trades around its book value of $13.66/fully diluted shares, at a time when its peers are trading at 1.5 times book value. Over the course of the next 2-4 years, Mercer should not only close the gap, but should trade at a premium to its peers due to it earnings potential. Keep reading to learn why.
Market: Mercer writes 75% of their business in New Jersey, and 25% in Pennsylvania. Part of the IPO proceeds will be used to expand their business beyond these two states. The mix of business is about 51% lines commercial and 49% personal lines. Given the lackluster results from personal lines, they are concentrating on expanding the commercial lines business to be about 75% of the business. Their niches in commercial lines are charitable organizations (churches, synagogues, non-profits) and locally owned apartment complexes. Commercial lines are centered on package policies (property, liability), with optional choices on work comp, auto and inland marine. They do not write stand-alone commercial auto policies. The personal lines business is your typical homeowners and personal auto policies, which are primarily processed through their in-house Internet application.
Insider & Institutional Buying: Insiders hold about 8% of the shares. Since so many policyholders exercised their subscription rights to buy stock, management, which was in the second tier behind policyholders, was cutback in their IPO buys. As a result, the CEO and two directors made open market buys of MIGP following the IPO. There has been one 5% holder to date, JMB Capital Partners/Jonathan Brooks, who holds 400,000 shares. I do not know Jonathan Brooks from Mel Brooks, which is due to my amateur status and nothing denigrating to Mr. Brooks. I did a search on him and his firm on the SEC web site and came across the following letter that he sent to Liquid Audio:
http://www.sec.gov/Archives/edgar/data/1016613/000111650202001033/jmb730.txt
After reading that letter, I am glad that I am investing alongside him.
Book Value: Here is how I derived the $13.66 book value. As of 9/30/03, Mercer had $38 MM of equity. They netted $54 million from the IPO, and they issued 500K shares @ $10/each for the remainder of Franklin Insurance, for a total of $97 million. For shares, I took 6.8 million shares and factored in an additional 4% for a stock option plan, which has not yet been voted upon by shareholders. I should note that the 6.8 million shares includes 626K ESOP shares plus the 500K for Franklin, for those wondering how they only netted $54 MM from issuing 6.8 million shares @ $10. Sandler O'Neill received a nice advisory fee, but not *that* nice. Tangible book is about $91 million ($3 million of existing goodwill as of 9/30/03, plus another $3 million of goodwill for completing the Franklin deal) or $12.82/fully diluted share.
In the prospectus, Mercer included an appraisal from Griffin Financial Group. If anyone looks at this, ignore the valuations specific to Mercer. Griffin made some unrealistic assumptions with regard to share counts, like subtracting the ESOP shares, that varied by scenario. Overall, Griffin understated the share count, thus making Mercer appear cheaper than it was at the offering. What was helpful is that Griffin compared Mercer to 14 other insurers. As of August 2003, Mercer’s peer group was trading on average at 1.34X book. I updated the share prices on those companies, and Mercer’s peer group now trades at 1.51 X book. To obtain a premium to book, though, Mercer will have to generate some dough. To the earnings!
Earnings: Mercer has historically been a profitable insurer. From 1998 through 2002, they had combined ratios between 93% and 96%. Mother Nature was not as kind to Mercer in 2003, and they will probably have a combined ratio around 99%. Historically, Mercer has generated 10% ROE’s. I believe that they should be able to achieve that level going forward, and possibly improve upon it. One problem is that Mercer has not fully deployed the capital that they have raised – yet. Let me discuss this more.
$26 million of the IPO proceeds were downstreamed to the insurance subs, giving them somewhere around $65 million of capital to write insurance. Assuming 10% ROE, that is $6.5 million in income or $0.92/share. That will not occur in 2004, but it is possible in 2005. Hard to get too excited about an insurer trading at a forward P/E of 14.7. So let us talk about the remaining $28 million held at the holding company level. $3 million will provide capital improvements to their systems and building space, so they have $25 million to go shopping. The CEO has stated that he will expand Mercer beyond their current territory, possibly through acquisition. With a pristine balance sheet, Mercer has room to take on debt, probably as much as $35-40 million without sacrificing their "A" rating. I mention leverage because there are not many insurers selling for $25 million, at least not desirable ones.
The one thing I did not like is that Mercer has a high expense ratio of 44%. Their average commission is 20%, in part because they reward agents through a bonus/profit-sharing plan for placing their better business with Mercer. That leaves 24% to cover overhead, which, in my opinion, is high. I do have to concede that due to Mercer’s small size, fixed costs weigh more heavily on their expenses. Increasing their writings will let them achieve better scale on their fixed costs. They also have two other cost savings in the works.
One of the expenses they can trim is premium taxes. This is a complicated matter involving retaliatory taxes with NJ. When Mercer Mutual changed their domicile from NJ to PA in 1997, NJ said that they are subject to a retaliatory tax, which Mercer is appealing. Mercer has paid/accrued for this, but is doing so under protest. There is no downside in their appeal, and if they win, they could receive as much $2.4 million back. Going forward, Mercer will nullify the effect of the retaliatory tax by shifting business to their NJ domiciled company. As a mutual, Mercer was legally prevented from doing this shift as policyholders would have lost rights because the NJ subsidiary was a stock (non-public) company. This would save about $600K per year.
The second expense savings will occur in-sourcing their IT services. Part of the IPO proceeds, $1.3 million, will be used to complete their IT infrastructure project. Mercer had for years relied upon a service bureau to perform much of the policy processing and a large attraction for buying Franklin Insurance was their internet based software for policy processing and agent servicing. They expect to save $700K per year by dumping the service bureau and doing it themselves. The two savings total $1.3 million pretax, $819K after taxes or $0.12/share. Add that to the previous $0.92 EPS, and we are at $1.04/share EPS.
But wait, not only can Mercer save money, they can make more money. The offering also fundamentally changes Mercer’s equity base in such a way that using a historical ROE-derived EPS estimate will not capture.
Mercer has a conservative investment philosophy. As of 9/30/03, 60% of the portfolio is in bonds, of which 80% are government issues. The rather high 25% in equities is distorted by their largest equity position, Excess Reinsurance Company, which they received gratis when Excess Re demutualized. These shares are not publicly traded. Most of the other equities are blue chips. The remainder of the portfolio is invested in preferred stocks and other income oriented investments. As to the portfolio’s earnings power, Mercer will benefit from a rise in interest rates (This year? Next year? When Greenspan departs?). From 2000 to 2002, their investment yield on the portfolio dropped from 4.0% to 2.8%. This should reverse itself over the next two years. There is an interesting dynamic here because the investment yield in prior years was dragged down by the large equity portfolio. The IPO monies will greatly change the investment portfolio, by making the equity portfolio less dominate and allowing them to achieve a higher effective yield.
Investment income is the key for Mercer (and all other insurers). Premiums are to insurers as deposits are to thrifts. The two fundamentals here are don’t lose money on insurance, and make money off the float. At this point, Jeff175 is probably wondering what all this translates into concerning earnings (hold me to that ACAP benchmark – geez). First thing to consider is that a more typical yield for an insurance company portfolio would be 5% to 6%. Second, the investment portfolio was $70 MM as of 9/30/03, so add $51 MM of IPO proceeds (net of $3MM in capital spending), plus $6 MM from consolidating Franklin’s investment portfolio onto their balance sheet. Thus, their current investment portfolio is $127 MM and, they will expand that as they increase their premium writings, either through growth or acquisition. With their new capital deployed, Mercer could have a $175 MM investment portfolio in three years. Multiply that by 5.5%, divide by 7.1 million shares, and investment income in 2006 could be $1.36/share. Throw in $0.25/share in underwriting profit, and you have 2006E EPS of $1.61. Apply a 15 P/E to that, and you have a $24.15 implied stock price.
Let me explain how I arrived at $0.25/share of underwriting profit. From 1998 to 2002, Mercer had an average underwriting profit of $550K per year, with 1999 being the top year at $1.3 MM. Factor in the previously discussed cost savings of $1.3 MM ($819K after tax), scaling into the fixed costs through expansion as well as earning more on increased premiums, and achieving $1.8 million in underwriting profit is doable.
Cons: The CEO, Andrew Speaker, is relatively young and an empire builder (but hey, he is a good golfer). One of the first things he did upon becoming CEO was make the deal for Franklin Insurance Company (not to be confused with Franklin Mutual, a separate melodrama involving Mercer). I can almost understand the rationale for buying an insurer for their policy system, but at least buy one that makes money. The fact that he intends to use the IPO proceeds to expand, including possible acquisitions, is a risk. Another risk is nature. Their 2003 earnings were negatively impacted early on by winter storms, and then Hurricane Isabel dampened 3rd Quarter results.
Catalyst
- Cheap relative to peers, providing downside protection
- Improving costs
- Growing premiums and investment portfolio
- New Jersey