Description

Short PLMR, a wildly expensive (P/BV > 5x) specialty property insurer beloved by the momentum crowd with no real competitive advantage. Downside potential of ~70%. Palomar is not a tech company; revenue growth for an insurer is quite different vs. a software business. 

Palomar is a specialty property insurer focused on the earthquake risk across residential and commercial lines. They offer admitted insurance (not E&S) in a handful of states with particular concentration in CA and West Coast. PLMR was founded in 2014 by Genstar and went public in April 2019 at $15 per share. It now trades at $47 after surging above $60 with very little fundamental basis for the advance. PLMR has grown its book of business rapidly in a few short years from $17mm in gross premiums in 2014 to $252mm in 2019.  

Sell side bulls have cheered the growth and scrambled to raise the target price each quarter. I believe investors should be cautious of this growth given the risks involved in rapidly scaling any financial product. Insurers focused on growth over profitability can write low quality business where the loss content may not be understood for some time. And the P&L is a self-graded exam, so the optimistic earnings are printed in advance. I believe this is well understood by most investors so I won’t expand upon this. Meanwhile, the insurer can tell a great story to naive investors. Buzz words often found in press releases include: disciplined growth, proprietary tech, niche business lines, etc. Flashy high flying growth companies in the insurance market often suffer a hard landing when the momentum crowd sours. 

It appears the tide is turning, so I am presenting what could be classified as a valuation short. I believe that the capital intensive nature of the business within a stable industry limits the risk that PLMR continues to run wild with an unsupportable stock price. KNSL was recently written-up and the story is similar here.   

Valuation:

PLMR’s P/BV multiple of 5.1x is detached from reality. Further, the company uses adjustments to juice the reported ROE, but even if the 20% was real, a 5.1x multiple would not make sense. I believe a more reasonable expected ROE is in the mid-high teens. 

P&C insurers are most commonly valued on P/BV with ROE (and expected changes in ROE) as a key driver. 

Moreover, on an earnings basis, PLMR is valued richly at 22.5x 2020 Adjusted EPS (consensus) where earnings are extrapolated into the future at favorable loss and expense ratios without any hiccups. PLMR is also given the benefit of various add-backs vs. competitors who don’t use this nonsense. Using a normalized 2019 figure, I estimate they are trading at 41.7x 2019 EPS. Even using consensus numbers, the stock is expensive on a P/E basis at 22.5x. It wouldn’t be abnormal for an insurer to trade at a high P/E if the reference year included abnormally high loss costs or something similar. But that is not the case for PLMR. Basically, 2020/2021 estimates assume everything goes right for the company. Unlikely. This earnings stream should not be capitalized at an average multiple, let alone a premium one. 

PLMR is the only quake focused specialty property insurer, so there is no direct peer. But its business is similar enough to a wide group of other insurers. The growth profile makes it unique. Most comps to PLMR trade at 1.0x-2.0x BV with a few exceptions for the best companies with a long history of profitable underwriting and growth (RLI/PGR/AMSF). There are so many different ways you can play with comp set and regression to show something is undervalued or overvalued.  

Street analysts cite KNSL as a peer, mostly because that stock also trades at an absurd valuation. Further, Bulls often include KNSL and RLI in the peer set to offer a highly biased average P/BV multiple. 

Financials: 

Top-line growth has been the story as 2019 GWP jumped from $155 million in 2018 to $252 million in 2019, up 63%. Since PLMR is a heavy user of reinsurance, net written premiums lag gross premiums significantly. NWP for 2019 was $144 million vs. $72 million in 2018. 

Revenue was $246 million in 2019. Consensus expects $324 million and $389 million for 2020 and 2021. This represents top-line growing 31% in 2020 and 20% in 2021.

The company’s adjusted combined ratio for 2019 of 63.3% included a loss ratio of 5.6%. The expense ratio is high due to their lines of business and distribution. It is likely also negatively impacted by the rapid growth. The loss ratio is low because PLMR’s primary line of business is low frequency, so you would expect modest losses most years.  

Non-GAAP EPS was $1.73 in 2019. Consensus expects $2.09 and $2.56 for 2020 and 2021. 

PLMR relies on heavily adjusted earnings. The company is aggressive in its financial reporting by excluding stock-based comp and other expenses from adjusted EPS and also including realized and unrealized investment gains in its preferred earnings metric (diluted adjusted EPS). The company also uses questionable methodology on the tax rate for earnings add-backs. In 2019, the tax rate on adjustments was 4.0% vs. PLMR’s 41.2% overall effective tax rate. Using the overall 41.2% rate would have reduced adjusted EPS significantly. Further removing the realized gains, Adjusted EPS would have been $1.13 in 2019. 

The company reports an impressive Adjusted ROE of 24% for 2019. As noted above, this excludes some very real expenses and includes gains from the investment portfolio that are non-recurring in nature. If one were to use the $1.13 cited above, the ROE falls to a more pedestrian 15.7%. And this includes benign loss experience.  

Book value per share as of 12/31/19 was ~$9. This has gone up a bit since the January secondary, but I am using the reported number because there may also be a negative impact on PLMR’s book value from the corporate bond-heavy investment portfolio. Either way, whether $10 or $9, the stock’s current multiple is seriously divorced from reality.  

PLMR’s balance sheet has with no debt. Gross/Net premiums to equity are 1.2x/0.7x. 

The investment portfolio consists mostly of corporate bonds and MBS/ABS. So some loss content here despite generally skewing towards higher rated securities. Fixed income accounts for 91% of the portfolio, while equities account for 9%. The amount classified as equities includes a mutual fund tied to the investment grade bond market. The duration of the fixed income portfolio is 3.5 years (which includes cash component) and avg. credit rating is A1. 18% of the portfolio is BBB or BB. 

Investments to equity is ~1.1x so not a ton of leverage to the bond portfolio.  

Business Mix:

PLMR is 67% quake insurance (by 2019 GWP), 13% specialty homeowners, 12% commercial all-risk with hurricane and flood representing most of the balance. 

By state, PLMR writes 56% of its business in CA, 18% in TX, 5% Hawaii, 4% Washington and 18% other. 

26% of premiums are commercial vs. 74% residential. 

Earthquake (“quake”) insurance is a low frequency, high severity business with expense ratios /cost of distribution and low loss ratios (most years). Generally, homeowners insurance does not cover quake risk. In CA, PLMR competes against the non-profit California Earthquake Authority. 

PLMR management will say that they price business better than others due to a granular approach. Per PLMR filings: 

“We use proprietary data analytics and a modern technology platform to offer our customers flexible products with customized and granular pricing on an admitted basis. We distribute our products through multiple channels, including retail agents, program administrators, wholesale brokers, and in partnership with other insurance companies.“

Who doesn’t use proprietary data analytics and a modern tech platform? 

PLMR touts its substantial reinsurance program which limits losses. They retain $5 million of risk per event on earthquake, up to $1.2 billion. This is great when reinsurance is available cheap, but may come to bite them if the market re-prices the risk.  

Product is distributed by retail agents, program admin and wholesale brokers. But premiums are concentrated with program admins at 59% of 2019 GWP. Arrowhead alone accounts for 36% of 2019 GWP. So there is risk in terms of concentration here.    

Management is aggressively growing its commercial lines which it expects to eventually reach 50% of premiums. This includes lines outside of quake such as commercial all risk and inland marine. Investors should view these diversification efforts with skepticism because they are outside of PLMR’s core area of expertise. In a more rational environment, investors might discount the valuation for these efforts. Instead, they have assigned a huge premium for speculative growth.   

The bulls are excited about rate growth. I will concede that it is likely they are obtaining better rate in this environment. But how much of that is already priced into the stock? And how much is due to rising loss trends which will be felt via higher ultimate loss ratio?

Management:

I don’t have a strong opinion on management, positive or negative. The use of adjusted earnings to back out stock based comp does indicate that they are willing to push the envelope in order to tell a better story.

Prior to founding Palomar, CEO and management ran Arrowhead General Insurance Agency, a program administrator which is part of Brown & Brown. 

Management owns 6.6% of PLMR’s stock, so they have skin in the game.  

In my mind, they have not proven to be excellent underwriters of insurance. Although they have experienced modest amounts of favorable PYD, there is only a limited sample size. Management’s core competency seems to be selling the story to the Street. Aside from Genstar’s sales, mgmt. has sold $10 million of stock since the IPO.    

Trading Dynamics:

Palomar sports a market cap of $1.1 billion and is well covered/well loved by the Street with all Buy ratings.  

~300k shares trade per day. 52 Week High is $62.96 vs. $18.06 52 Week Low. Short interest stands at ~3% of shares outstanding, around 2 days of volume. 

A recent secondary in early January saw Genstar sell down more of its stake from ~36% to ~15% at $49 per share. This came after a similar secondary on September 30. With Genstar selling down its stake, what was once a tight float is becoming less so.   

Impact of Recent Events:

PLMR’s core business is not directly impacted by the coronavirus. On the margin, they could see slower penetration for quake products and lower retention in other areas, but relatively minor vs. others. Its investment portfolio may see a hit from the selloff in corporate bonds, but leverage is modest and other P&C names have much more exposure. Typically, lower rates pressure net investment income, and it is likely they put new money into treasuries at lower yields.   

Outlook: 

Management recently guided to 2020 adjusted net income of $50.5 million to $53 million with no mention of what potential adjustments might be. The midpoint translates to roughly $2.09 or 22.5x at current price. 

I have no reason to believe that revenue growth will slow and my thesis does not rely on a breakdown of growth or realization of loss content. I believe that this growth is inappropriately valued in the market currently. It is risky and should be discounted appropriately. 

Conclusion:

In summary, I find PLMR to be a decent insurance company with an insane valuation. The valuation suggests a competitive advantage which simply does not exist. They are in a commoditized business and any fool can grow premium for a few years. 

Heavily adjusted earnings in a benign loss environment are being capitalized at obscene multiples to sell the growth story to investors. If it traded back to its IPO price (less than a year ago), this would represent a decline of almost 70%. Trading to $20, which would equate to ~2x BV would represent an almost 60% decline from Friday’s close. 

P&C stocks are considered a port in the storm. A place for people to hide in ugly markets that aren’t as levered to wider economic issues. In my view, value will become relevant again. The tide turning on passive and momentum flows provides a nice tailwind here. I also think the risk/reward on “safe haven” stocks is more favorable now vs. tickers that have already been severely penalized. 

Risks:

How important will “industry-leading growth” be to the market over the next 6-12 months? There is risk that this has something interpreted as scarcity value. 

Investors may flock to P&C names with relatively sterile balance sheets and business lines uncorrelated to the wider economy. PLMR hits all of those boxes. 

The status quo from the past few years, where valuation and fundamentals rarely matter, may continue. 

Recent benign loss trends continue with solid earnings momentum. 

I don’t think an announced acquisition would be viewed favorably by investors, but could be wrong.

Catalyst

A more skeptical market environment