Description

The Phoenix Companies, PNX, is a life insurer that trades at 0.23x P/TBV, a 7.6 p/e on run-rate earnings and with a shareholder friendly management team and catalysts to unlock value in the next 12 months. The opportunity exists due to investor disinterest because the company is undergoing an unfortunate, but benign restating of GAAP financials. The company has not done any capital management since the financial crisis, though this will change upon restatement and, in addition, there are no sell-side analysts actively covering the stock. PNX is worth at least $70/share (50% upside) within the next 12 months based on $40/share of excess cash at the holdco which should be returned to shareholders through a special dividend or buyback and a residual value of $30/share ($130 TBV after capital mgmt x 0.23x P/TBV = $30/share residual value).  There could be upside to over $100/share if the P/TBV multiple expands to 0.5x which is below the lowest in the peer group, DTAs are used which could add $44/share, or there is an M&A event.

Business

PNX demutualized and IPOed in 2001, selling life insurance and annuity products to HNW customers through independent agents and financial advisors. In early 2009, PNX lost its investment grade rating due to reduced core profitability, weakened financial flexibility, and large losses in the company’s investment portfolio. In March 2009, in response to the ratings downgrades, State Farm and National Life Group, PNX’s two largest distributors, suspended the sale of PNX’s life and annuity products which reduced PNX ability to grow the business. PNX shifted their business to less capital intensive, less ratings sensitive businesses leveraging the company’s existing strengths. PNX’s now has two segments:

• Life and Annuities - Individual life and annuity products including the closed block from State Farm and National Life Group. Following the downgrade, PNX’s target market for new sales consists of middle market households with a variety of financial planning needs, such as tax-deferred savings, safety of principal, guaranteed income during retirement and modest death benefits. Phoenix’s typical customer is between 50 and 80 years old, with an average annual income of $60,000 and an average net worth of $625,000.
• Saybrus Partners – Provides dedicated life insurance and other consulting services to financial advisors in partner companies. Saybrus’ primary business is selling products into other life insurers businesses.

Given the loss of investment grade rating, the new business written hasn’t kept pace with organic runoff. Revenue and operating earnings are expected to decline for the foreseeable future because PNX’s new businesses do not have the same growth potential and capital requirements. As the business runs off, it will continue to generate positive earnings and excess capital which can be upstreamed to the holdco and returned to shareholders. Management plans to reduce the amount of capital at the company to meet the smaller opportunity set they are seeing today.

Restatement

On November 8^th 2012, PNX reported an error in the classification of universal life deposits that were reported in cash flow from operations when they should have been reported in cash flow from financing. When PNX opened their books, they found additional errors related to valuation of certain insurance liabilities and deferred policy acquisition costs, accounting for complex reinsurance transactions, and valuation of certain private debt securities and derivative investments. Importantly, the restatement has only had a $28.0MM impact on statutory capital (~2.5% of stat capital) as of 3Q13 which indicates that the restatement is primarily due to classification of the journal entries rather than significant problems with reserves or capital levels. As of November 15^th, 2013 PNX announced that their stat results can continue to be relied upon. PNX has provided updates on the restatement process on March 15^th, April 24^th, May 22^nd, and June 28^th. In addition, the company has provided statutory earnings and other key metrics to monitor the business each quarter during the restatement process. One way to reduce the risk of investing in PNX is to wait until the restatement is complete and then buy PNX on the capital management story.

Valuation

There are three sources of value in PNX shares

1. Tangible book value of $167/share.
2. DTAs with valuation allowances worth $44/share which are not included in BV. 43% of NOLs expire between 2014-2016, the remainder expire after 2022.
3. Saybrus Partners is a capital-light, fee-based business.  Valued at 5x EV/EBITDA, Saybrus is worth $3/share.

In recent quarters, PNX has continued to upstream capital from the regulated life opco to the holdco. Cash at the holdco is fully unencumbered by regulators and management has discretion regarding where capital is deployed and on the timing. Since 2011, holdco cash has risen from $101MM to $201MM in 3Q13. Annual holdco interest and fixed costs are $25MM and management has said that they would like to keep 2 years of fixed cost coverage at the holdco or $50MM. This means that there is $151MM (56% of PNX’s market cap) of cash available at the holdco today that can be immediately deployed through share repurchases or a special dividend after the restatement is complete. In addition, PNX has regulatory approval for $78MM of annual dividends from the opco to the holdco which I expect management to fully utilize each year. Therefore, after one year of dividends from the opco, the holdco will have $229MM of excess cash which can be used to pay a special dividend of $40/share, nearly equal to today’s market cap. If management were to pay the dividend, the remaining business would have a book value of $130/share, $44/share of DTAs, and $3/share value in Saybrus. If the business after the dividend continues to trade at a 0.23x P/TBV which is where it trades today, the residual value would be $30/share. Combining the two, you get a $70/share fair value. It isn’t difficult to envision a scenario in which PNX trades to 0.5x P/TBV as management improves capital management, runs off the business, or sells the company. In that case, PNX would be worth $104/share.

PNX has the lowest P/TBV in the life insurance group at just 0.23x. The next cheapest life insurer is NWLI and trades at 0.55x P/TBV, but does not have excess capital to return to shareholders. After NWLI, the next 5 cheapest life insurers are 0.7-0.8x P/TBV. Also, PNX trades at just 5x P/E and continues to generate positive albeit declining earnings.

Investments

In 2009, PNX had issues because they had a riskier investment portfolio including more structured products and private equity. PNX took $370MM of OTTI losses on its investment portfolio which hurt EPS during 2009-2011. However those assets have mostly recovered in price as risk assets have rallied to all-time highs. The increases in value are not reflected in PNX’s book value because the securities are mostly classified as held-to-maturity.

DTAs

There isn’t a clear path for PNX to use its DTAs, but they still provide a potential source of value. The company’s tax advisors have suggested a couple ways to monetize the DTAs, but management has not made any plans yet because they are focusing on the restatement.

Capital Management Background

PNX had been organically rebuilding capital and restructuring the business during 2009-2012 and did not do any dividends or repurchases. Management was at the cusp of ramping up capital management in late 2012 before the announced restatement in November 2012. On September 26, 2012, PNX announced that it had repurchased $48.3MM of its surplus notes for $36.2MM (accretive to book value and EPS) and authorized a $25MM share repurchase program. This was the first capital management since the financial crisis because PNX had rebuilt capital and had defined its operating businesses which do not require as much capital. Management was planning to execute the repurchase program after they released 3Q results. Unfortunately, the restatement was announced so they have been unable to repurchase stock. However, holdco cash has grown from $119MM to $201MM from 2Q12 to 3Q13, so there is room for additional capital management.

Earnings

PNX generated $94MM of TTM statutory earnings or $16.20/share. However, profitability has declined in recent quarters to $8.7MM in 3Q13 or a $6.00/share run-rate stat EPS. Given they are still in their restatement period, the company does not give great color around what has driven results. However, we know that PNX’s life insurance business continues to runoff and free up capital so some level of declining earnings is expected.

Importantly, PNX has upstreamed $97MM of capital to the holding YTD with $29MM in 3Q13. I expect dividends to the holdco to exceed net income for the foreseeable future as PNX runs off its life insurance business. Once the capital is at the holdco, PNX can use it for dividends or share repurchases.

While there were clearly mistakes in PNX’s filings, management appears to be shareholder friendly.

• Between March and June 2012, eight insiders bought 400,000 shares. Also, during 2009, 2010, and 2011 insiders bought stock in the open market.
• Announced capital management in September 2012 including repurchase of surplus notes and equity.
• Because the stock was so low, the board did not want to issuing large amounts of equity as incentive comp which would dilute shareholders. They instead made incentive compensation variable to the stock price performance over the vesting period.
• The investor relations person is easy to contact and is helpful and honest.

Catalyst

• Executing the existing $25MM share repurchase authorization. If executed over one year, PNX would buy 10% of the daily volume every day during the year. This would be a strong tailwind for a thinly traded stock.
• Announcing and executing capital management plans for the remaining $126MM of excess capital which is available today at the holdco.
• Continuing to upstream $78MM of cash to the holdco each year and returning it to shareholders.
• Monetizing DTAs.
• Regaining investment grade rating. While this isn’t a priority for management, they could regain the IG rating over time which would allow them to underwrite new types of business.
• A rising rate and rising equity market are positive tailwinds for life insurance businesses.