Description

Merchants Group is an unusual insurance holding company that provides property and casualty insurance to business and individuals in the northeast and mid-atlantic states.

MGP is valued at just 82% of book value, with a PE of 9.4x. The company is in the 7th inning of a long process to extract itself from a semi-captive arrangement with a mutual insurer, and in February, announced that they have retained an investment banker to explore strategic alternatives.

I believe that MGP will enter an agreement within the next 18 months that allows them to realize book value in a transaction during 2008. Along the way, there may be a few signposts to help, but first, let’s review the business and its recent performance.

Effectively, MGP has no operating assets and no employees. Under a services agreement, Merchants Mutual Insurance Company (from here on, simply Mutual) provides all the facilities and personnel for MGP. Essentially, MGP is the financial entity that underwrites a percentage of Mutual’s business. In 1998, Mutual attempted to buy MGP, but the conflicts were too obvious, so MGP gave notice that it was terminating the operating agreement in order to eliminate this conflict.

MGP had to give five years notice, and so beginning Jan 1st, 2003, the two entities finally entered a new agreement that would allow MGP to extricate its capital in phases. In 2005, MGP’s pooling arrangement is 30% of the business traditionally underwritten by MGP/Mutual. This is down from 35% in 2004 (the pooling arrangement allows for a decrease from 40% in 2003 to 25% in 2006-07). Also, beginning in 2006, MGP will be able to solicit bids for the management of its investment portfolios.

As one would expect, a 5% decrease in MGP’s pooled share has resulted in 13.4% declining revenues (going from 35% to 30% is approximately a 14% decrease). What is interesting is that despite purposefully shrinking their revenues over the last four years, the earnings have been increasing significantly. While a PB below 1.0 often suggests a value trap might be lurking, a PE under 10 and a significantly underutilized capital structure would peak my interest even without the potential transaction catalysts.

Part of the improved earnings is due to a 2002 decision to stop writing new private passenger auto policies in certain jurisdictions, while allowing the more profitable commercial lines to grow.

MGP has already reported earnings of $2.87 through the first three quarters, as compared to $1.79 and $1.74 for the previous two years. Much of this has come from improved underwriting results. On a fiscal nine month comparison, their loss ratio has been 51.5% in 2005, down from 66.2% in 2004. Ten percentage points of that 2005 improvement came from favorable development of 2004 losses and loss adjustment expenses. Despite this favorable development, MGP hasn’t correspondingly adjusted their loss estimates for 2005. Hopefully there is another favorable adjustment down the road for this year.

MGP believes that the favorable loss development is consistent with increased fraud prosecution and prevention in New York State for personal auto, along with underwriting changes beginning in 2002 in their commercial auto lines. Furthermore, MGP’s made changes to its workers comp line in 2001 to reduce the concentration to high severity losses, and pre-2002 non-NY work-comp policies were favorably adjusted.

While this experience does not necessarily prove that underwriting has improved, it does suggest that there are favorable trends, and those favorable assumptions are important toward establishing a base case valuation of book value, since it suggests that book may be slightly understated. Since a small change in loss reserves makes a significant impact on earnings, it is important to establish the adequacy of reserve assumptions.

The expense ratio is higher than industry standards (38.3% last quarter), partially due to certain fixed expenses remaining while the pooling arrangement winds down. The expense ratio will remain high while MGP underutilizes its capital.




Relationship with Mutual and the case for Mutual to purchase MGP:

The mutual insurer (Merchants Mutual Insurance Company) has had a closely aligned relationship with MGP, and currently owns 12.1% of the common stock. From MGP’s IPO in 1986 and until a secondary stock offering in 1993, MGP was a majority owned subsidiary of Mutual.

There aren’t any options shenanigans, and there are other vested interests with significant ownership. One MGP board member personally owns nearly as much as Mutual, with 11.4%, while Franklin Microcap Value Fund (FRMCX) and Kahn Brothers are also significant holders.

MGP has already given notice to terminate the investment management services part of the agreement. Underwriting services may be terminated on one year’s notice, but may not be effective before Jan 1st, 2008.

An obvious place to start for valuing for MGP would center on book value. It makes sense that the most straightforward transaction would be for Mutual to pay book for MGP in approximately two years, or for MGP to simply do some variation on this riff (realizing book value). In fact, MGP could effectively close down with the intention to run out the book and simply return the capital at the beginning of 2008. While this may not be optimal, it should still produce a positive return to shareholders and a compelling return if combined with an expedited slimming of the excess capital. This scenario at least demonstrates that MGP can enhance shareholder returns by simply walking away from mediocre merger terms.

But I’d prefer to examine the simplified base case valuation as “book + 2006-07 reduced earnings = 2008 exit price”. Since the beginning of 2008 is nine quarters away, and revenues will be declining, I’m going to go with an earnings assumption of $4.00 for the next nine quarters, which is a 32% decline from the $5.89 earned for the current trailing nine quarters.

Ignoring dividends, this would bring book value from $35.97 to approximately $40. A sale there would be a 33% gain over a little more than two years, or a 15% IRR between now and Jan., 2008.




Strategic alternatives:

From 1999 to 2002, the company steadily bought back shares, reducing its share count from 2.60 million to 2.11 million. If they are not going to make a sale, it makes sense that they reestablish these buybacks while the stock is below book value. They have already increased the dividend to $0.25 quarter, for a 3.4% yield. Absent a sale, there are other ways to slim the capital structure. More on this later.

According to their filings, the decreasing amount of the business assumed under the pooling agreement is intended to provide capacity to pursue insurance opportunities independent of Mutual. Given what appears to be a conservative loss reserve, MGP might not be willing to sell itself as cheaply as book value, but instead might find another arrangement with a more profitable underwriter than Mutual. Since there are so few mutual-stock insurance structures, there are not a lot of publicly traded examples of how this gets resolved. However, the logic is very straightforward—why sell a dollar of book value for less than a dollar?

One thing that I wondered about was how Mutual might be able to improve its underwriting standards to such a degree that it could retain MGP as its partial backer. With 315 employees, Mutual would not only be the natural buyer, but has the incentive of needing to replace MGP’s capital without disruption. But I’m not sure that the problem of MGP underperformance is all Mutual. Underwriting appears to have improved, but the primary restraint on MGP’s recent earnings is that it was simply overcapitalized for Mutual’s needs, yet didn’t have enough capital to explore other alternatives.

There is a significant obstacle to the natural outcome of Mutual buying MGP—there’s a decent chance it doesn’t happen. Mutual has a statutory surplus of $74M with $16M in surplus notes. P&C insurers are typically allowed approximately 35% debt-to-equity. If Mutual bought MGP at book value, that would be $74M + $76M = $150M. While Mutual could carry $150M in equity with $50M in debt, that would still leave them short. (I know that I’m simplifying the accounting here, consider this a crayola-version of the regulatory balance sheet.)

Mutual does own 12%, so they only need to buy the 88% they don’t own, but that still leaves them short. That raises the possibility that they could simply purchase a majority interest and keep MGP captive. This raises a lot of questions, and I don’t consider it likely, and not only because they have been working since 1998 to avoid such a sub-optimal transaction. It simply doesn’t seem likely that major holders could move forward without the participation by the board member who owns 11%. And it is doubtful that a board member would approve selling his stake in a transaction that might leave a disgruntled minority share group.

MGP is currently underwriting at a vastly underutilized pace. From the 10-Q: “Regulatory guidelines suggest that the ratio of a property−casualty insurer’s annual net premiums written to its statutory surplus should not exceed 3 to 1. MNH has consistently followed a business strategy that would allow it to meet this 3 to 1 regulatory guideline. For the first nine months of 2005, MNH’s ratio of net premiums written to statutory surplus, annualized for a full year, was .7 to 1.”

In other words, MGP (MNH in the 10-Q) has significant excess statutory surplus. If push comes to shove, there is plenty of room in the capital structure for MGP to figure out a transaction that allows them to do a combination of a return-of-capital, stock buyback, and a sale to Mutual. But hey, that’s what the hired gun investment banker is for—I’m not going to spell it out for them without a cut of the fees.

Let’s take what we know already. MGP is at 82% of book, disentangling from the Mutual, but leaving Mutual so that its capital situation remains fine all the way through to the end of 2007. In a way, Mutual is having its feet held to the fire by the stepwise process in the pooling agreement. If it doesn’t replace Mutual, it will have to underwrite less business. To preserve its mission and employee resources, there is a decent chance that Mutual might have to demutualize in order to raise the money to purchase MGP. While many mutual institutions are reluctant to demutualize, this may just force the issue.

Despite the obstacle of Mutual simply not having the cash to make a simple outright purchase, walking through the pitfalls of this scenario simply demonstrates how underutilized MGP is as an insurance underwriter. 0.7 to 1 is very conservative in an industry where 1.5:1 and 2:1 are common. And that 0.7 will fall even further as the pooling arrangement further decreases MGP’s share of the underwriting in 2006 and 2007.

MGP raised the quarterly dividend from $0.10 to $0.25 less than a month ago. In light of the various choices, this makes tremendous sense. It is also considerably less than they are allowed to dividend, so they could in theory dividend just under $3.00. However, even slimming that fast wouldn’t solve the problem of Mutual being able to buy them by 2008, especially since they are on pace to make that much in earnings this year anyway.

The case for owning MGP is not dependent on Mutual purchasing MGP when the services agreement ends. While it makes a lot of sense, I view it as providing a base floor for price and timing when MGP decides among its options. One thing to consider is that if Mutual does intend to demutualize, it will need to get the regulatory approvals, and that would accelerate MGP’s convergence to its takeout price. Mutual needs to make these decisions within the year, so it is logical to me that the end-game might be telegraphed well before the end of 2007.

Examining the rationale for Mutual to purchase MGP at book value suggests that many insurers would explore a similarly priced transaction. So there may be more upside than I’ve suggested. Of course, MGP could stumble and make a dilutive merger or combination with some other insurer or agency, but I’d give MGP the benefit of the doubt on any transaction that has them leaving Mutual. After all, which of MGP’s zero employees are mis-incentived to make a bad deal?

Catalysts:
1) MGP is in year eight of a ten year process to realize its independence as financial entity.
2) They have increased the dividend and hired an investment banker.
3) Convergence to book value in two years produces a compelling risk-reward.

Catalyst

1) MGP is in year eight of a ten year process to realize its independence as financial entity.
2) They have increased the dividend and hired an investment banker.
3) Convergence to book value in two years produces a compelling risk-reward.