Description

Penn Treaty (NYSE: PTA : $2.00)

Penn Treaty American Corp is an insurance company that provides Long Term Care and Home Health Insurance. PTA was a pioneer in LTC insurance and their stock went on a strong run in the late nineties when the industry really began to take off, reaching heights of more than $30 per share. But in early 2001, after mistakes in the company’s actuarial assumptions decimated reserves, shares went into a tailspin. Regulators barred PTA from selling new policies and the company was forced through a painful, dilutive restructuring. Today the stock floats around $2.00 per share, implying a market cap (fully diluted with all converts) of around $190 million.

Sounds like a dud, eh?

Well, last year Penn Treaty completed their restructuring and its shored up balance sheet has won them regulatory approval to renew selling policies in 40 states. Management projects 2005 earnings of $0.30 a share, up from an expected $0.20 a share in 2004, capping off an excellent turnaround. By this time next year, I expect PTA to trade at least 12 times its 2005 number, indicating a 61% increase to $3.60 a share.

In a growth industry, with experienced and disciplined new management, PTA is an unloved, undiscovered undervalued small cap with no real analyst coverage.

What is Long Term Care (LTC) insurance?

If you’re under 40, you probably haven’t heard about long term care insurance (although that perception is rapidly changing, more on that later). Long term care insurance protects people from the cost of caring for themselves as they grow older, whether it is a disability or a disease that keeps them from being able to govern their own well-being. LTC insurance typically covers custodial care and skilled nursing care in either your home or a nursing facility.

Penn Treaty first started offering long term insurance in 1972, when these policies were called nursing home insurance. They launched their first home healthcare product in 1983. These three products account for 96% of revenue:

1) The Assisted Living(R) policy, which provides coverage for all levels of facility care and includes a home health care rider.

2) The Personal Freedom(R) policy, which provides comprehensive coverage for facility and home health care.

3) The Independent Living(R) policy, which provides coverage for home and community based care furnished by licensed care providers, as well as unlicensed caregivers, homemakers or companions.

Long Term Care is on fire

A recent article from March 22nd from Barron’s does a fantastic job discussing LTC and its outlook:

“Sales of long-term care insurance have been surging recently by about 18% a year, with younger buyers leading the way. The average age of customers -- 72 in 1990 -- has plunged to about 58, says the Health Insurance Association of America, a trade group. So far, fewer than 10% of all adults in the U.S. have bought the insurance, with about seven million policies now in force.

“The fact is, an estimated 42% of those who reach 70 will need some form of long-term care, says the federal Agency for Health Care Policy and Research. And those needs are sure to increase as people live longer and longer. The final phase of life, when living with eventually fatal chronic illnesses, has the most intense costs and treatments, according to a study by the Rand Corp. of Santa Monica, Calif.

“The study also found that while previous generations tended to die suddenly and at home, baby boomers will probably die in hospitals, and will usually spend two or more of their final years disabled enough to need help with routine activities.

“By the way, you don't have to be geriatric to end up in a nursing home. Uncle Sam finds that 18% of nursing-home residents are under 64 -- often people recovering from serious illnesses. The insurance can cover those stays, too.”

According to a 2001 report by the Centers for Medicare and Medicaid Services, the combined cost of home health care and nursing home care was $20.0 billion in 1980. By 2001, this cost had risen to $132.1 billion. These costs are projected to rise to $158.8 billion by 2004.

So, who needs actuaries anyway?

Between 1995 and 2000, Penn Treaty was very successful at one thing, selling policies. Consumer Reports even rated their product the best long term care policy for consumers. Total in-force premiums grew at a compound annual rate of approximately 29% from $102 million to $360 million in those six years.

The stock traded near $30 a share between 1998 and 1999, as growth stocks attracted many fans. But the company had one dirty little secret: it was not putting effort into properly pricing policies or asking for rate increases on its insurance products. Penn Treaty did not employ a single actuary up through 2001, despite the rapidly growing $300 million plus book of business.

What happened next was not surprising. The company started to see a sharp rise in claims and losses. This ate into its insufficient capital base and PTA’s share price collapsed. Nervous regulators forbade Penn Treaty from selling new policies anywhere. And their statutory capital ratio fell to a miserable 1.1 to 1. Any number below one and regulators would have seized control.

New management to the Rescue?

The new CEO Bill Hunt joined the company in 2001, when the company was in crisis. Mr. Hunt most recently served as Vice President and Chief Financial Officer of the Individual Life Insurance Unit of Prudential Insurance. He also served as Vice President of Corporate Planning and Development for Provident Mutual Life and had various financial management roles at Advanta Corporation, Covenant Life Insurance Company and Reliance Insurance Companies. Mr. Hunt is a CPA, who has over 15 years experience in the insurance business. He began his career as an auditor.

Bill Hunt has turned out to be exactly the executive that PTA needed, someone from an accounting and financial management background who could reengineer the business and save Penn Treaty.

Mr. Hunt also brought in four new actuaries, including Bruce Stahl, who became the company’s chief auditor. From 1994 to 2001, Mr. Stahl owned BAS Actuarial Services, an actuarial consulting services firm. Prior to 1994, Mr. Stahl served as a consulting actuary for KPMG and as Assistant Actuary for American Integrity Insurance Company. Mr. Stahl is a graduate of the Wharton School of the University of Pennsylvania, and is a member of the Society of Actuaries and the American Academy of Actuaries. Mr. Stahl has over 25 years experience in the insurance business.

The CEO has also brought in some heavy hitters on the board to help bring experience and counsel to the company, including Matthew Kaplan from Oakbridge Capital Partners and Gary Hindes from Director of Deltec Asset Management.

So how are we going to turn this thing around?

With statutory capital at critically low levels, Penn Treaty had to quickly raise cash in order to avoid being taken over by regulators. A series of convertible preferred issuances raised over $100 million, getting the balance sheet back in shape. The mandatory convertible preferred shares were unfortunately highly dilutive to the original shareholders; the company currently has $90 million in convertible debt outstanding, representing almost 70% of the fully diluted share count.

So the original shareholders got screwed, but statutory capital was back over 4 to 1. PTA’s next task was to have actuaries crunch the numbers (novel approach!) and properly reprice policies. With more than 28 years of claims experience selling and servicing LTC and nursing home insurance, PTA’s actuarial team combed through old records looking for clues on how to improve the underwriting process. After getting their existing products whipped back into shape, Penn Treaty used this data to create and price one of the industry’s widest product lines. Because of they are one of the industry’s only pure play companies, PTA has been able to use their niche focus and experience to price and provide an unmatched breadth of LTC products.

Now that finances were back in order, the company needed to sell new policies (properly priced this time!) in order to grow. After the heavily reduction in statutory capital, Penn Treaty had been barred from selling new policies in all 50 states. Since the restructuring, Penn Treaty has aggressively campaigned in each state, winning back licenses in 40 states (they continue to pursue approval from the remaining ten). Management has learned from the company’s previous mistakes and has embarked on a conservative sales plan that will provide good shareholder returns without jeopardizing the all-important capital reserves.

Improved Metrics

The first quarter just reported showed several positive signs of progress in the turnaround. Sales from new policies on an annualized basis hit $4.2 million, up 68% from a year earlier. In the previous quarter, annualized sales from new policies were $14 million, up 105% from a year earlier. New applications that were running at 225 per week in January were at 240 applications per week in February and March, and are now over 250 in April for the first time ever.

The company saw claims expenses fall 8.5% in the first quarter and management expects claims to further fall in 2004. This is due to a new claims adjudication processing techniques (fight fraudulent claims), improved care management techniques (provide legitimate benefits at lower cost), and improved underwritten protocols (avoid high risk customers).

Also, the company reported that its statutory capital ratio, which should be above 200%, and in 2001 was as low as 110%, closed at 900% at year end, and is above 700% as of the first quarter. This means they are over reserved and ready for growth.

Convertibles and the real fully diluted share count

Due to a quirk of securities law, some 10-Q’s calculate EPS using only the 21 million shares of straight equity (according to GAAP, convertible shares are not counted towards EPS in any quarter when net income is negative). Please note that the real fully diluted share count to use for calculations is 82 million shares.

Convertible holders continue to convert debt to equity, $17.2 million in the first quarter. This reduces PTA’s interest coverage and leverage ratios. PTA targets becoming a debt free company by October of 2005.

Guidance

The company has issued the following guidance inclusive of fully diluted 86 million shares outstanding.

20-22 cents in 04
30-32 cents in 05
40-45 cents in 06 (my estimate)

The company is also projecting $30 million in new policy sales in 2004 and $45 million in 2005. I expect this to grow to $60 million in 2006.

What’s this thing about a “notional experience account”?

Penn Treaty holds a reinsurance policy with Centre Solutions that reinsures all of their old poorly written LTC policies (everything written before Dec 31, 2001). This reinsurance agreement was reached when the company was restructuring and PTA was required to transfer approximately $563 million in securities into a so-called “notional experience account.” This account is held by the reinsurer and basically collateralizes the reinsurance agreement.

Securities law requires that fluctuations in the notional experience account get reported as net income. This makes quarter by quarter earnings more volatile during times of fluctuating interest rates.

So why have the reinsurance agreement if it creates earnings volatility? Because it helps them make sales. Penn Treaty is rated “B-” by the rating agencies. Having Centre Solutions, which is really Zurich Financial, reinsure there policies allows PTA an “A” rated reinsurer which helps in marketing and it allows PTA to go in and grow a little bit faster and get new policies on its books.

The main risk with the experience account is that it will lose value when interest rates inevitably go back up. But a rise in rates is overall bullish for PTA (and other insurers). Why? The best way to look at the insurance business is that insurers are arbitraging the future value of claims expense against the future value of the reinvested premium collected. This is especially true for LTC insurance, where premiums are typically collected for many years (sometimes decades!) before any claims are made on the policy. So, when interest rates rise, this allows PTA to reinvest premiums more effectively, raising the future value of reinvested premiums and helping the company cover future claims.

If you want to penalize the company for interest rate risk, this is how I look at it. For every 100 basis points, PTA loses about $80 million from their “notional account.” So, it’s about $1 a share in book value. At the end of the year, book value was $3.16 a share, and the 10 year was at 4.25%. So, if interest rates were suddenly 5.25%, book value would be about $2.20 a share, which still makes the company trade under its book value. Remember this calculation is without the benefit of future retained earnings which will offset this amount (20 cents in 2004, 30 cents in 2005).

Also, a 1% jump in interest rates is a pretty big move. Gradual rises in interest rates, as projected by the Fed, will be much less damaging to future income. The real risk from here is a dramatic rise in interest rates. But isn’t this the risk for the market and most financial companies in general? And if you are worried about interest rate risk, you could easily short another financial, such as IFIN, which would plummet if interest rates dramatically soared.

The key overriding point is that the current valuation on PTA is so freaking low, it protects you against severe risks and a massive jump in interest rates.

One final point on the notional experience account is that Zurich Financial has decided to stop reinsuring health care insurance companies and PTA is expected to switch over to an alternate reinsurer in the next 120 days. This is a good thing, because the old Centre agreement was negotiated during PTA’s restructuring, when the company was on the ropes. They are now shopping the policy with three ‘A’ rated reinsurers and are in a much stronger position to negotiate the new agreement, as their balance sheet is back in order and business is booming.

Summary

So, you’ve got a company that is no longer in financial straits, that is starting to show strong sales and earnings growth that is trading at 9x 2004 earnings, 6.25x 2005 earnings, and a 40% discount to its current fully diluted book value.

You have new experienced and sharp management on the up-cycle after a three year painful restructuring process, rapidly growing sales, and shrinking claims expense. There are no analysts and no real institutional presence. This will change.

I also think that the 6.25% convertible notes (currently trading for approx. 115% of par) are a great opportunity to earn a nice coupon while participating in the equity upside. The notes are currently 25 cents in the money and manditorily convert into stock if PTA trades over $1.93 in October of 2005.

Catalyst

-analyst coverage
-A.M. Best or S&P insurance rating upgrade
-First sales in CA
-new product offerings
-2nd and 3rd quarter numbers continue to show sales progress and reduced claims expense