Description

Thesis:

Primerica is the Herbalife of financial services.  The Company is the only multi-level marketing (MLM) that targets the financial services space.  Primerica recruits “agents” who are largely lower income, underemployed and financially unsophisticated to sell fairly sophisticated products to other lower income, underemployed and financially unsophisticated people.   Primerica generally sells high priced products to those who can afford them the least.  Each prospective customer is also a prospective recruit.  Agents spend the bulk of their time trying to recruit other agents for the Primerica Dream instead of trying to sell the actual product.  While the business is generally “unsavory”, that does not necessarily mean the company is a short. 

However, in April 2015, the Department of Labor (DOL) announced it would repropose its fiduciary standard proposal to close a longstanding regulatory loophole that could potentially make the pyramid unravel.  This would completely change Primerica’s business model and make it very difficult for the Company to sell its mutual fund products at current fee levels.  We think the market has taken a wait and see approach to this proposed regulation and the impact of the proposal is not properly being discounted in the current stock price.  If the proposed regulation were to go through, which we think is very likely, Primerica is a $30 stock at best, or down 35% from current levels. 

While there are many companies that are going to be impacted by this regulations (LPL, Ameriprise, Raymond James, etc), we think PRI is the best way to play this.  Other brokers can shift their business model to negate some of the impacts of the regulation, which we don’t think PRI will have any success in doing. 

Business Description

Primerica was founded in 1977 by A.L. Williams who was best known for his slogan of “buy term and invest the rest”. It was spun off by Citigroup in 2010. The company sells through a multi-layer system of 98K career agents of which approximately 22K are registered representatives thereby making PRI the largest broker dealer in the U.S. It predominantly underwrites term life insurance and 80% of new sales are reinsured. PRI also sells a variety of other mutual fund, annuity and financial products, predominately through IRAs. It operates through two segments: Term Life and Investment & Savings Products (ISP). PRI does business in both the U.S. and Canada with earnings split 60% term insurance and 40% investment products. 

Investment Merits:

·         DOL Proposal Is Game Changing For the IRA Industry: In 2010, the DOL proposed new regulations that would change broker/dealers to fiduciaries, which is what registered investment advisors are already subject to.  Being a fiduciary means you have to recommend products that are in the best interest of your client and the advisor cannot be conflicted when offering this advice (meaning they can’t collect commissions).  Broker/dealers are only subject to the suitability test and can collect commissions which can cause conflicts of interest.  The ramifications of having Primerica agents becoming fiduciaries are far reaching and explained in further detail in this memo.    

·         Primerica Specifically Targets Those The DOL Is Trying to Protect: Primerica targets middle income consumers for IRA investments, those who makes ~$65,000 (most likely lower).  These consumers are generally financially unsophisticated and Primerica is incented to put these consumers into actively managed mutual funds that charge upfront loads of 5.75% and annual expense ratios of 1.25%+.  The vast majority of these consumers would be much better off either going directly to a Fidelity and avoiding the upfront load, or even better, having passively managed index funds / ETFs where expense ratios are 20bps.  The proposal specifically calls out lower income consumers being sold high fee products as something that is not in the best interest of consumers.  

·         In Order to Make Money at Primerica, You Have to Recruit: The definition of a pyramid scheme is when agents spend the majority of their time recruiting new agents instead of selling the product.  That is exactly what Primerica does.  You cannot make a living selling Primerica products because you only earn a fraction of the commissions of a normal broker dealer, whereas people in your upline take the majority of the commissions.  The only way you can make a living is if you continuously recruit new agents and earn commissions off of them.  Primerica recruited 190,439 agents in 2014, and its sales force only grew from 95,566 to 98,358, or a gain of less than 3,000.  The implied churn rate is astronomical! 

·         The Bulk of Investment / Savings Segment Growth has Come From Market Appreciation: From 2012-2014, 87% of the AUM growth in the investment/savings segment came from market appreciation, while only 13% is coming from net inflows (from 2010-2014 it was 7%).  New inflows are barely keeping up with redemptions.  Continued growth in this segment is going to be determined by further gains in the equity markets. 

·         Primerica Underwrites Profitable Term Insurance: Primerica is one of only a very few insurance companies that actually underwrite profitable term life insurance.  Most use term insurance as a loss leader to sell other products.  Primerica is able to sell its insurance profitably not because it pays lower commissions but because of the people Primerica targets.  Most broker/dealers sell insurance for multiple insurance companies.  They will compare quotes across 10+ different insurance companies and give their clients the best rate.  Primerica agents only sell Primerica insurance and most of Primerica’s clients are not sophisticated enough to shop around.  While I haven’t been able to confirm exactly how much more expensive Primerica insurance is, based on their benefits to premiums ratio being sub 40% when industry standard is 50-80%, it speaks to the pricing Primerica is charging above the industry.  While this won’t necessarily end anytime soon, it speaks to how Primerica takes advantage of financially unsophisticated consumers and is indicative of how its fees will be impacted on the broker/dealer side from the DOL proposal.  . 

Variant Perceptions:

DOL Proposal Will Make Primerica Model Untenable: Normally, a proposal that would completely change the industry would make us nervous because there would be too much lobbying and it would be stopped.  But the way the DOL proposal is being structured, it will disproportionately impact PRI more than anyone else.  While other broker/dealers will not necessarily be happy, they will be able to continue as a going concern.  The same cannot be said for Primerica.  The average Primerica agent only makes $5,600 in commissions per year (median is probably much lower).  If this is reduced even by a small amount, the ability to continue to attract additional recruits will be reduced significantly.  If Primerica cannot continue to attract new recruits, its business model will die.  More so, Primerica’s mutual fund agents (the 22,600 of the 98,400 total agents) are considerably more productive than the other agents.  The DOL proposal is impacting Primerica’s most product agents, who will likely look to other broker/dealers who have a better product offering if commission are reduced. 

PRI Is Most Impacted But Least Followed Amongst Brokers: We started shorting PRI ahead of the proposal given the complete lack of attention investors were giving the proposal to PRI.  While the stock is off ~10% since the release of the proposal, we still think PRI is flying under the radar given the lack of sellside cross coverage amongst PRI and the other larger brokers being impacted (LPLA, AMP, etc)

Management Is Aware of the Proposal:  PRI had a co-CEO structure.  Both co-CEOs, Rick Williams and John Addison, announced their retirement in January 2015, effective April 1st 2015.  Both Co-CEOs will remain on the board including Rick Williams being the chairman of the board.  Rick Williams has sold out of almost 100% of his stock since the end of 2013 including selling his remaining 45% since the initial memo was leaked saying the DOL was going to re-propose the fiduciary duty rules.  John Addison, the other Co-CEO, has sold 75% of his holdings since the end of 2013 and 32% since his leak.  While the CEO selling could be explained by their retirement, given both will remain on the board including one as Chairman, as well as both have been with the company for 25-30 years, it’s surprising to me they would be this aggressive with their sales unless they were truly concerned of this proposal. 

DOL Proposal History

In 2010, Phyllis Borzi, shocked the industry by submitting a proposal to change a loophole that has been around for 40 years that gave two separate designations that provide financial “advice” to consumers.  The more stringent is the Registered Investment Advisor (RIA), who must adhere to the fiduciary standards.  This standard indicates that an RIA cannot benefit from the advice they are giving on a specific product, even if the customer is benefitting more.  Basically, what this means is RIAs have to charge a fixed fee (usually a % of assets) for the advice they are giving and cannot collect commissions on the products they sell.  Alternatively, broker dealers do not have to adhere to the fiduciary standard.  They only have to comply with the suitability test, meaning the product has to be suitable for the consumer but it does not have to be the best product available.  This means that broker/dealers can collect commissions on the products they sell.  There is an inherent conflict of interest here because the broker/dealer is incentivized to sell high priced products to consumers.  Consumers generally use investment advisors because they don’t understand the products in which they are purchasing and assume they are getting the best advice possible when working with an investment advisor and do not understand the differences between working with the two. 

Phyllis Borzi, who views this proposal as her baby and her way to change the world, submitted a proposal in 2010 to change broker/dealers to fiduciaries (PRI agents are broker/dealers), which effectively meant they were no longer able to charge commissions.  Phyllis did not complete a feasibility study, which is what the Office of Management and Budget uses to assess the economic impact of the proposal.  She also did not conduct any real market research on the impacts of this proposal on the broker/dealer industry.  Nor was the White House squarely backing the proposal.  By not doing her homework and by not getting the White House on board, she left herself open to attacks. 

The proposal was largely dead on arrival because of this.  Obviously Republicans do not like any forms of regulation.  Lobbyists swarmed the issues and were able to make the argument that if you removed commissions then the broker/dealer business model was not sustainable for low balance IRAs.  This would substantially reduce access to financial advice for low income consumers, which scared the democrats as well.  Both sides of the aisle wrote letters expressing their concerns with the proposal.  Ultimately the DOL had to withdraw its proposal given the lack of support. 

The DOL went away for almost 4 years with this issue.  Every now and then, rumors would start swirling that the DOL was going to reissue the proposal but the timing kept getting pushed back.  With the mid-term elections being rather disastrous for the Democrats, and with Republicans controlling both the House and Senate, Obama shifted focus away from legislation and to regulation, as regulations do not have to get approval from Congress.  In January 2015, Jason Furman, the Chairman of the Council of Economic Advisers to the White House, leaked a memo he had written that implied the White House had firm support of re-proposing the fiduciary standard rule.   On February 23, 2015 Obama gave a speech at the AARP giving the talking points of the new proposal and indicating he was fully on board with the new proposal.  They also released a 31 page report that outlines their research on the matter as well as the impact to individuals in receiving “conflicted advice”. 

We have spoken a number of industry lobbyists who were involved in both the 2010 proposal and the current proposal.  They believe there is an 85%+ change that this proposal goes through, largely in its current form for a number of reasons:

1.       Phyllis (and the DOL) did their homework.  She did a request for information from the industry.  She commissioned research to support her arguments.  Whether the research is true or not is irrelevant.  Previously, she had nothing to back up her argument so lobbyists could use the argument that no one would sell to these people anymore if this regulation goes through.  Her new research indicates that no advice is better than conflicted advice, so it becomes incredibly difficult for people to combat this argument. 

2.       The White House is squarely onboard with this and Obama and been asking Democrats to be silent on the issue.  For the most part, Democrats have largely not been vocal on the issue thus far. 

3.       The DOL has softened the language and still allows for commissions/12b-1 fees to be a form of compensation to broker/dealers.  This was the largest sticking point in the last proposal because many IRAs have too small of an account balance to make enough money by charging a fixed % of AUM.  The DOL recognizes this and will still allow brokers to collect “reasonable” commissions. 

4.       There is not enough opposition in the Republican Party to attach an appropriations rider to the DOL budget forbidding the DOL to use its budget because ultimately Obama can veto the bill and then there are not enough votes on both sides to push through the appropriations rider. 

Review of Proposal

Broker Dealers get paid through a variety of ways broken out below

1.       Upfront Commissions: Typically called loads, these are paid by the consumer to the broker.  There are multiples classes of shares that have different fee structures.  Primerica typically sells A Shares, which come with high upfront loads.  We have pulled a significant number of equity mutual funds from Primerica’s website which should they were charging on average 5.75% upfront loads.  As shown below, this was at the extreme end of the competitive set.  It should be noted that if a consumer were to go directly to a mutual fund provider such as Fidelity, they would offer their own products at no-load.  Similarly, passively managed index funds or ETFs have no upfront load. 

It should also be noted that actively managed mutual funds have been in secular decline for some time with the advent of ETFs and other passively managed index funds.

Even worse for Primerica, front load funds have also been significantly declining.  According to the Invesco:

Class A shares (i.e. shares w/ loads and 12-b-1 fees) are archaic and Invesco has been actively moving away from those – they  said the whole industry is moving away from those types of share classes naturally – basically it’s up to the distributor what type of share class they want, but most people today want the shares without loads…he cited Primerica as being one of the few players that still strongly prefers to distribute load shares (has to also do with minimum balances – small minimum balances are far more likely to end up in these Class A shares)

2.       12b-1 Fees: In additional to the upfront load, Primerica clients are charged an annual expense ratio.  After pulling a significant number of mutual funds that Primerica offers, the average is 1.25%, which is again at the very high end of the range.  Of this 1.25%, ~25bps is a 12b-1 fee, which is paid back to the advisor who sold the mutual fund. 

3.       Revenue Sharing: These fees are generally not disclosed upfront to the investor and are known as “back-door” payments in the industry.  Mutual funds will pay fees to companies like Primerica to incentivize them to sell their products.  There are three ways to compete in the mutual fund business 1) Better Quality 2) Lower Fees and 3) High Revenue Sharing.  By offering high revenue sharing, the distributor is incented to offer those that are not competing on quality or lower fees.  These backdoor payments are at the heart of what the DOL is trying to stop. 

As shown in the data above, Primerica offers the highest fee products out there.  There is no way Primerica is going to be able to justify selling these products at current fee levels once the proposed regulation is finalized. 

Selected Talking Points from Proposal

The Department expects the proposal to deliver large gains for retirement investors. Because of data limitations of the academic literature and available evidence, only some of these gains can be quantified. Focusing only on how load shares paid to brokers affect the size of loads IRA investors holding load funds pay and the returns they achieve, the Department estimates the proposal would deliver to IRA investors gains of between $40 billion and $44 billion over 10 years and between $88 and $100 billion over 20 years. These estimates assume that the rule will eliminate (rather than just reduce) underperformance associated with the practice of incentivizing broker recommendations through variable front-end-load sharing; if the rule’s effectiveness in this area is substantially below 100 percent, these estimates may overstate these particular gains to investors in the front-load mutual fund segment of the IRA market. The Department nonetheless believes that these gains alone would far exceed the proposal’s compliance costs, which are estimated to be between $2.4 billion and $5.7 billion over 10 years, mostly reflecting the cost incurred by new fiduciary advisers to satisfy relevant PTE conditions.

Many advisers do not accept backdoor payments or hidden fees and work on a different business model that puts their customers’ best interest first. They are hardworking men and women who got into this work to help families achieve their dreams and want a system that provides a level playing field for offering quality advice. But outdated regulations, loopholes, and fine print make it hard for working and middle class families to know who they can trust.

These incentives cause some Wall Street brokers to encourage working and middle class families to move from low-cost employer plans to IRA accounts that typically entail higher fees—and to steer working and middle class families into higher-cost products within the IRA market. Many advisers currently act as fiduciaries and provide advice in their clients’ best interest, but many others do not.

The Department’s proposal will continue to allow private firms to set their own compensation practices by proposing a new type of exemption from limits on payments creating conflicts of interest that is more principles-based. This exemption will provide businesses with the flexibility to adopt practices that work for them and adapt those practices to changes we may not anticipate, while ensuring that they put their client’s best interest first and disclose any conflicts that may prevent them from doing so. This fulfills the Department’s public commitment to ensure that all common forms of compensation, such as commissions and revenue sharing, are still permitted, whether paid by the client or the investment firm.

The DOL proposal is principals based and it is very clear from the reading the proposal that the DOL has been extremely careful to make it seem like they are not telling the broker/dealer industry how to run their business, which was the problem with the 2010 proposal.  The DOL is merely saying you cannot offer conflicted advice and while you can still accept commissions, you have to make sure you can justify why you are offering the best products available to your consumer. 

This puts the industry in an extremely difficult spot.  The proposal is extremely vague on the actual implementation and it puts brokers at considerable liability if they don’t act in the best interests of their clients, which is extremely subjective.  It is clear that the talking points that while commissions are still allowed, the intent of the proposal is to cut fees to lower income consumers.  Unless you offer the lowest fee product, you open yourself up to the legal liability of having to justify why you put your clients into a high fee product.  The DOL is trying to use the invisible market hand to drive down commissions. 

Implications to Primerica

Primerica put the following new language in it is 10-Q, which came out right after the proposal:

On April 14, 2015, the DOL published a proposed regulation (the “DOL Proposed Rule”), which would more broadly define the circumstances under which a person or entity may be considered a fiduciary for purposes of the prohibited transaction rules of the Employee Retirement Income Security Act and IRC Section 4975. IRC Section 4975 prohibits certain types of compensation paid by third parties with respect to transactions involving assets in qualified accounts, including individual retirement accounts (“IRAs”). The DOL Proposed Rule fulfills the announcement of the DOL in September 2011 that it would withdraw a proposed rule published in October 2010 and propose a new rule defining the term “fiduciary”. Simultaneously with publication of the DOL Proposed Rule, the DOL proposed a package of exemptions (the “Prohibited Transaction Exemptions”) intended to allow advisers and their firms to continue to receive common forms of compensation that would otherwise be prohibited due to the DOL Proposed Rule, provided the conditions of the exemptions are met. The DOL has requested comments on the DOL Proposed Rule and plans to hold a public hearing following the close of the comment. We are hopeful that the DOL will be receptive to the comments it receives and make certain adjustments to the Rule and the Prohibited Transaction Exemptions to fulfill its interest in protecting the savings of middle income retirement savers.

IRAs and other qualified accounts are a core component of the Investment and Savings Products segment of our business and accounted for a significant portion of the total revenue of this segment for the year ended December 31, 2014. Thus, if the DOL Proposed Rule and its accompanying Prohibited Transaction Exemptions are finalized in their current form without modification, we would expect to make adjustments to our fee and compensation arrangements for qualified accounts. Such changes could make it more difficult for us and our sales representatives to profitably serve the middle-income market and could result in a reduction in the number of IRAs and qualified accounts that we serve, which could materially adversely affect the amount of revenue that we generate from this line of business and ultimately could result in a decline in the number of our securities-licensed sales representatives. Furthermore, we would anticipate increased compliance costs and our licensed representatives could be required to obtain additional securities licenses, which they may not be willing or able to obtain.

The form, substance and timing of a final rule are unknown at this time. It is possible that a final rule could be adopted in a form that does not materially adversely affect us or that Prohibited Transaction Exemptions could be modified or issued in a manner that minimizes the impact. If adopted in the form proposed, however, the DOL Proposed Rule could have a materially adverse effect on our business, financial condition and results of operations.

Heightened standards of conduct as a result of either of the above proposals or another similar proposed rule or regulation could also increase the compliance and regulatory burdens on our representatives, and could lead to increased litigation and regulatory risks, changes to our business model, a decrease in the number of our securities-licensed representatives and a reduction in the products we offer to our clients, any of which could have a material adverse effect on our business, financial condition and results of operations.

Trying to discern exactly where Primerica makes its money is difficult from the financials.  However, we know they make their money predominately from 1) Upfront Loads 2) 12b-1 Fees and 3) Backdoor Fees.  We also know that Primerica pays out the bulk of the upfront loads and 12b-1 fees to its agents, but keeps the backdoor fees for itself.  Primerica does not disclose exactly how much they are earning from these back-door payments, but it’s possible to try and triangulate. 

After reading the 1,000+ pages of the regulation (found here if interested: http://www.dol.gov/ebsa/regs/conflictsofinterest.html), we find it almost impossible to envision a scenario where these backdoor payments fit into the fiduciary standard.  While the DOL does not forbid backdoor payments, the writing of the proposal makes it almost impossible to justify how these are not conflicted payments.  If backdoor payments were to go away, profitability at Primerica would suffer dramatically without impacting the actual independent broker/dealers from offer their services.

Below is an outline of PRI and how Primerica makes its money:

As shown above, investments/savings make up approximately 40% of pre-tax profit before corporate expenses.  Backdoor fees make up ~50% of the net commissions PRI collects, but 82% of Investment/Savings Pre-tax profits.  What this means is the business could still exist (i.e. PRI could still pay its commissions to its advisors) even if these payments went away, but PRI as a company would just make significantly less money. 

Ultimately, it could be much worse than this given that PRI is putting its clients in funds where they charge an upfront load of 5.75% and annual expenses of 1.25% when you have alternative products being priced with no loads and much lower expense ratios.  The DOL proposal allows for “reasonable” commissions but does not define what reasonable is.  The new fiduciary rule will put pressure on these firms to offer much more competitively priced products, which will limit the commissions they are able to charge.  Furthermore, given that PRI is so dependent on recruiting new agents, which is largely dependent on selling the dream of the business opportunity of selling PRI products, any cuts to commissions will likely put pressure on new recruits.  If this happens, it will be very difficult for this to not have a spill-over effect into the life insurance business. 

There is also the possibility that licensing requirements will be stricter if it’s deemed that Primerica is offering financial advice.  Right now, only 18% of new recruits actually take the test and pass.  Part of this is because they quickly realize that the Primerica dream is not all it’s cracked up to be.  But part of it is because the quality of people Primerica recruits cannot always pass the insurance test.  Securities recruits (the 23k out of the 98k) have to take even more rigorous tests which include the Series 6 and Series 63.  If Primerica tried to shift its business model to a registered investment advisor (RIA) model, the agents would have to take the series 65 test which is materially more difficult.  The number of licensed agents will assuredly go down if they are forced to take this test. 

We lay out 3 scenarios.

1.       Bull Case – The proposal is withdrawn or the proposal lacks any teeth.  The stock goes back to $52, where it was prior to the DOL proposal.  Upside risk is ~12%.  If the proposal does go through but compliance costs still go up, upside will be less than 12%. 

2.       Base Case – we assume that the backdoor fees go away and compliance costs go up by $10M as they have a much higher duty in making sure they are offering products that are in their best interest. 

3.       Bear Case – we assume the backdoor fees go away and commissions come down slightly.  Compliance costs go up by $10M and the life insurance business does not grow because they have difficulty recruiting new people.

Timing

The DOL published the proposal in the federal register on April 20, 2015 and has allowed for a 75 day public comment period which would end of July 4^th, 2015.  However, there has been some lobbying efforts to extend the comment period to 120 days (average comment period is 90 days).  Secretary Perez has pushed back on an extension given the amount of industry involvement that has been incorporated both from the 2010 proposal and the most recent proposal.  Assuming the 75 days comment period holds, there will be a public hearing 30 days after the comment period ends around August 3^rd.  .  They will then open it up to public commentary and will release the final ruling sometime between October 2015 and April 2016 with an 8 month effective date thereafter.  Below is a helpful timeline. 

Public comments will start coming out towards the end of June.  We will be watching the public comments very closely.  Several brokers including Bank of America and LPL have already come out with general support of the DOL proposal. 

Risks

The DOL Proposal Does Not Go Through: There is always the probability that the proposal does not go through, or it’s watered down so much that there is no impact on the business.  While this would ultimately be an undesirable outcome, given the stock has only traded down 10% since the DOL proposal was publicly released, there is not that much upside if it fizzles. 

Continued Strong Buybacks: PRI pays a 1% dividend and repurchased 5.5% of their shares last year.  All in, they have repurchased 25% of their shares since their IPO in 2010. 

Continued Strength in the Equity Markets: So much of the growth has been tied to a strong equity markets.  Consensus has modeled in 7% appreciation in the markets (combined equity + debt markets), further upside will likely cause small earnings b

Catalyst

Further regulation from DOL/SEC and associated earnings deterioration from PRI as they comply.