National Financial Partners (NFP - $21) is a leading independent distributor/broker of financial service products – life insurance, benefits and p&c insurance – to high net worth individuals and to businesses. For a variety of reasons, which I will discuss below, NFP is out of favor and is selling at a very attractive price, almost 65% below its all-time high, for whatever that is worth.  We believe that NFP is selling at less than 7x its 2008 cash EPS, and approximately 9.5x its FCF (which I will define), even though it continues to experience decent organic and acquisition growth, with the prospect of growth reaccelerating over the next year.  We believe that this reacceleration will be a key catalyst for the stock to go significantly higher, but also that the current level of earnings and cash flow is extremely solid and that the stock has minimal downside.

 

NFP was founded in 1998, with initial backing from Apollo Management, to roll up leading, independent life insurance brokers.  Jessica Bibliowicz, who is the daughter of Sandy Weill, was recruited to run the company from the beginning, and by all accounts she is a strong CEO.

 

From early on, the company developed an acquisition structure which is maintains to this day.  The structure is well described in the 10K, but a brief summary is as follows.  NFP looks at the earnings of a business before owners’ compensation, which it calls target earnings.  NFP buys 100% of the business, but only the first 50% of earnings, which it calls the Base Earnings, and the second 50% goes to the former owners, or whoever has succeeded them in running the business.  The original purchase prices have generally been 5-6x Base Earnings, paid in a mix of cash and NFP stock.  So, post-acquisition, NFP gets the first 50% of earnings before owner’s comp, the principals get the second 50%, and they split all earnings above the original target earnings.  After 3 years, the former owners can receive an earn-out payment equal to a multiple of the original base earnings if they can achieve average annual growth of at least 10% during the earn-out period.  The earn-out multiple starts at 0.5x original base earnings and can be as high as 5x for 35% or more average annual growth.  After the earn-out period ends, principals at the acquired companies get 3-year incentive plans, under which they can earn significantly more than the 50% share of earnings, based on their ability to continue growing earnings at a rate of at least 10% annually.  At 35% average annual growth during incentive period, the principals can earn 40% of NFP’s share of that growth, meaning that at 35% growth, NFP would only realize 21% growth in its share of earnings.  The incentive payments are paid out every three years.   The most important thing to note about this structure is that NFP’s base earnings are very secure, but that it does not participate fully when the companies experience very strong growth.  Another interesting aspect of this structure is that principals of acquired companies never fully cash out.  50% of the earnings, plus the incentive plans, remain in the business to compensate them or their successors.

 

NFP got off to a strong start, and by the time it went public in 2003, at $23, it had acquired 132 companies, was operating at a $500 million revenue run rate and $50 million of cash earnings (as defined by the company as Net Income plus all D&A), and had been experiencing fairly steady, 10-15% organic growth at its companies.  Post-IPO, the momentum accelerated through 2005, when NFP achieved 22% organic growth, and into early 2006.  From that point on, business slowed abruptly, and same “store” growth has been only slightly positive.  What happened?  In the years 2003-2005, a business known as non-recourse life settlement exploded, and then ground to a near halt, partly by NFP’s conscious choice.

 

The life settlement market is the market through which people can sell their insurance policies to investors or institutions, who will continue paying the premium and then ultimately collect the death benefit.  Generally, you can get much more selling whole life insurance into the settlement market than what the original carrier will give you in cash surrender value.  What happened starting a number of years ago, and accelerating dramatically in 2003-2005, is that some smart insurance brokers figured out that the life insurance companies price policies for 70-80 year old males assuming that a large number will have lapsed (people will stop paying premiums) or been surrendered (for the highly discounted cash surrender value) before the death benefit is paid.    I have heard that lapse and surrender rate assumptions were as high as 80-90%.  What this meant is that the steep profits from lapsed and surrendered policies - which never pay a death benefit - were in effect subsidizing policies that were held until death, and that the policies held until death were getting very high implicit returns.  Brokers started putting together deals where a 70 year old man buy a $2 million policy, an investor group would put up the money, and the man could pocket up to 10-15% of the face amount of the insurance without any risk (other than having to live with the idea that a non-family member would collect $2 million when he dies, and hoping that the investor would not do anything to accelerate the realization of the investment).  Generally, the investors would pay the premiums for two years, and then sell the policy to GE, Berkshire Hathaway, or one of the other insurance companies in the life settlement market.  Like any “good idea”, these deals became extremely popular, and brokers serving high net worth clients focused serious efforts on them.  Tens of billions of dollars of insurance was written before the carriers and the regulators figured out what was happening; obviously, this market is very bad for the carriers if they are still assuming 80-90% lapse and surrender rates.

While this was happening, NFP was enjoying tremendous organic growth – 14% in 2004, 16% in 2004 and 22% in 2005 – but was either not fully aware of what was fueling it, or did not come clean with the market.  By the spring of ’06, the insurance companies were up in arms, and regulators (including our favorite former governor Elliot Spitzer) were investigating.  As the largest broker, NFP took the lead in clamping down on it.  The real target was the non-recourse part of the market, where the person getting insurance did not put up or go at risk of putting up any money.

 

Life insurance is one of the oldest business still around.  Nearly $2 trillion in face amount of individual life insurance is purchased annually in the US, and there is more than $10 trillion of individual insurance in force.  The business has been a steady grower, averaging 6% annual growth in premiums on new individual policies purchased from 1996-2006, and similar growth over much longer time periods.  Over the past 20 years, there have been 4 down years in terms of new purchases, with the worst drop being 3%.  Another notable trend has been a shift away from agents affiliated with one carrier only towards agents who work with multiple carriers, as NFP does.  There has also been a marked increase in the average size of new policies, from $90,000 in 1996 to $166,000 in 2006, suggesting that life insurance is becoming more of a high net worth/estate planning tool, another trend that favors NFP.

 

As internal growth decelerated and 2006 guidance came down, NFP’s stock fell from the high $50’s in late 2005 to the mid $30’s in mid-2006, but the company did not materially change their long term guidance of 15-20% annual cash eps growth.  Cash eps growth was 30% for 2005 and 4% for 2006.  Guided by the company, the market expected growth to bounce back in 2007, and the stock recovered to the high $50’s.  However, the business is heavily 4^th quarter weighted (although that is changing), and as that quarter unfolded at clearly lower growth than the market was expecting, the stock fell from $55 at the end of October to as low as $17 in March.  You might ask, how big was the earnings miss to drive the stock down so much?  Well, cash eps was $2.61 in 2006, and as of 10/31/07, was projected to be in the range of $3.05 for 2007.  The actual number was $2.67, or $2.86 before a 1x cost relating to the buy-out of the principals’ remaining economic interest in a company that NFP is turning into a platform where it did not want to have to deal with the complex division of the pie.  Internal growth ended up at zero for the year, which, among other things, shows the stability of the earnings.

 

While the company was dealing with this growth slowdown, which was mainly due to the life settlement market but probably had something to do with the economy and financial markets in the past 6-12 months, it has continued investing heavily in its corporate infrastructure.  It has built out a technology and service platform to deliver quotes and other pricing and policy data to its group of companies and has standardized many of the systems.  In addition to the New York City corporate headquarters (which it is relocating this quarter to larger space that will also house a number of their NYC based operating companies), NFP has also built a major operation in Austin, TX to service their network of companies.  As it has transitioned from being a real roll-up with not much infrastructure to being a real company with significant corporate services and infrastructure, corporate SG&A has grown,  In fact, SG&A, which is all corporate, has been stuck since the IPO in the range of 25-26% of Gross Profit, which is NFP’s share of earnings from its companies.  Thus, they have not enjoyed any operating leverage to date.

The other major development, which should be very positive longer-term, had been NFP’s expansion in to the benefits market.  In the past two years, almost all of NFP’s acquisitions have been in the benefits area, and non-life revenues are now approaching 50% of total revenues.  The benefits business is much more of a recurring revenue business than life insurance brokerage, and also tends to enjoy annual cost increases.

 

 

The week Bear Stearns blew up in March and financial stocks got creamed, Barron’s ran a very negative article on NFP, questioning its entire business model, discussing a handful of lawsuits involving NFP-acquired companies or principals of those businesses, pointing out that the cash eps that the company reports (it also reports GAAP eps) does not take d&a and goodwill write-offs into account, and suggesting that the roll-up model doesn’t work.  I am sure the claims about lawsuits were correct – it is hard to imagine that a company with a few thousand somewhat independent people selling life insurance does not have a handful of lawsuits outstanding – but I think that the overall conclusion is way off.  NFP has very strong cash flow, whose downside has proven to be as resilient as one would think given the deal structures, and has had only minor write-offs.  The company has taken some impairment charges, averaging $8 million per year for the past three years, but on actual dispositions, firms representing around 4% of total acquired base earnings have been sold through 12/31/07 for net gains.  The important thing is not what they have written off, but what they are generating from the businesses they still own, and what value they have created overall.  It’s sort of reminds me of the line from the movie The Whole Nine Yards, where Bruce Willis, playing hit man Jimmy Teduski, says, in defending his character “it’s not important how many people I’ve killed.  What’s important is how I get along with the people who are still alive”.

 

Over the past six months, and probably as a response to the poor stock performance and the Barron’s article, NFP has beefed up its IR disclosure (see the NFP web site/IR section and the past 3 or 4 presentations for good disclosure on performance by year of acquisition and other operating and financial data) and just had a poorly-attended investor day a few weeks ago. 

 

The company’s current strategy is to continue doing accretive acquisitions using its well-honed structure, paying 5-6x Base Earnings, with a goal of buying at least $20 million of Base Earnings every year, paying an average of 50% in cash and 50% in stock .  NFP acquired $34 million of Base Earnings in 2007, and is already close to hitting the target for 2008. 

 

Cash flow is strong and growing.  Earn-out payments spiked up in 2006 and 2007 due in part to the delayed impact of the life settlement spike, and there is one more large earn-out payment due this year for Highland, a $50 million acquisition (the largest to date when done in 2005) that hit its full earn-out target.  Thus, we estimate that earn-out payments will total $25-30 million this year, and then fall to a more normal level of $15 million annually in future years.  Likewise, capx has been running $10-15 million annually until this year; we expect it to spike to $25-30 million due to $13-15 million spent on the new corporate offices.  The company is actively buying back stock, and had bought back $9 million in the first quarter.  We believe NFP will likely buy back at least $25 million in total this year.  Given the FCF of $73 million this year, or $98 million normalizing capx and earn-out payments, the company can fund the cash portion of acquisitions internally, and buy back enough stock to retire more than ½ the stock it is issuing in acquisitions and earn-outs.

 

The company has also said it expects to begin achieving significant operating leverage on G&A.  This year, G&A growth will be 5-6% excluding a $3 million one-time cost relating to the corporate office move.  The company suggests it can keep G&A growth around these levels going forward, even as it grows Gross Profit 12-15% annually from the combination of 2-5% organic growth and 10% growth from acquisitions.  This should lead to 10-15% annual cash eps or FCF per share growth.

 

Subject to the economy, the company expects to begin experiencing positive comps again this year, and did achieve 5% internal growth in the first quarter.  Given the long term growth of the life market, and a very rough estimate of 5-8% annual growth in the benefits market, 5% organic growth seems very reasonable.  Since inception, NFP has significantly out-performed the industry’s growth rate.

 

Finally, we believe that the company’s accounting is conservative – it is one of the few companies I am familiar with that does not present an adjusted EPS that includes the add back of stock-based comp

 

 

The summary financial statements are below.  We believe there are several different ways to look at EPS.  The company reports GAAP EPS, which includes a large amount of D&A (much higher than capx), as well as goodwill impairment, gains or losses on dispositions of businesses.  It also reports Cash EPS, which adds back Deb&A and goodwill impairment.  The analyst community accepts this definition of EPS, and has tended to pretty much ignore GAAP EPS, although given the current stock price, Cash EPS is clearly not a credible number.  Below, we show our slightly modified definition, which also excludes the impact of gains or losses from dispositions.  Another theoretically difficult issue is how to deal with earn-out payments.  The company has not done a good job of disclosing them, burying them in the cash flow line item for payments for acquisitions.  We have broken them out below, and have deducted earn-out payments as well as capx in what we call Free Cash Flow, or FCF.  The one other wrinkle is that both earn-out payments and capx are much higher than normalized this year, so we have also shown it on a normalized basis.  Another reasonable way to deal with earn-out payments would be to ignore them for the FCF calculation, but deduct the next three years’ of expecting payments from the market or enterprise value, as that would cover the earn-out payments on everything they have will have acquired through the end of 2008.  That would make the FCF multiple even lower.

 

We have put together two projection cases – Low and Base.  The Low Case assumes no organic growth this year, and 2% annual organic growth in future years, whereas the Base Case has 2% organic growth this year and 5% in future.  The company would probably say that their low case is our base case, and their base case might be 6-8% annual organic growth.

 

We would argue that the company should trade for 15x FCF, taking everything into account.  Historically, it traded for 15-20x forward Cash EPS, as defined by the company, and our FCF number is substantially lower than Cash EPS.

 

 

 

Investment Merits

-         strong, very stable cash flow, generally not cyclical

-         potential to resume steady >10% annual growth in all important metrics

-         trading at very cheap multiples on absolute and historical basis

-         company is coming off of 2 years of ok but disappointing results where it did a poor job of managing street expectations

-         the best roll-up model we have seen in terms of properly incentivizing principals

-         except for acquisitions, company operates and grows with very little need for capital, including almost no net working capital

-         as this write-up shows, it is a complicated story, which probably helped the stock when it was flying high, and is clearly hurting it now.  We would bet that the pendulum will swing back at least part of the way.

Risks

-         the biggest risk is that the government does something to fundamentally change the estate planning attributes of life insurance.  As far as we know, this has not surfaced in any political platforms or discussions of estate tax, unfair benefits for the rich, etc., but if it happened, it could be devastating to the industry

-         a continued weak economy could lead to another few years of negative or zero internal growth

-         the benefits business is now tied to the health of corporate America, and in particular to white collar employment

-         new accounting change this year might require NFP to accrue $10-12 million of additional “imputed” interest on their $230 million of 0.75% convertible debt due in 2012, with a $75 conversion price.  This would impact GAAP earnings by up to $0.16 per share, but has no economic impact or impact on Cash EPS or FCF.