Description

Phoenix Cos. (PNX - $14.90) is a AA- rated life insurance, annuity and asset management company that recently demutualized. There is 55% upside to my estimate of its fair value today, and further value creation potential as a result of an improving ROE, a strategic alliance with State Farm, it’s strong position in the highly attractive high net worth market and the possibility of a takeover in the distant future. The market cap is $1.6 billion, with 105mm shares outstanding.

I valued the company on a sum of the parts basis.

1) Investment Management Segment

PNX’s products include mutual funds (23% of AUM), managed accounts (19%) and institutional products (58%). The asset managers include Roger Engemann, Seneca, Duff & Phelps, Zweig and Walnut. Although PNX has all investment styles represented, it is weighted toward growth. After experiencing net outflows in 2000 of $957mm, net inflows were $1.4 billion in the first half of this year. I valued this segment at 2% of assets under management (AUM) of $54.8 billion, for two reasons. At the beginning of this year PNX bought out the minority shareholders in its investment management subsidiary at 2% of AUM. In addition, this valuation is very near the low end of publicly traded asset managers, so I think it is conservative. (As an example, Affiliated Managers Group recently bought a 51% interest in Friess Associates, a growth shop, for 6.8% of AUM). Therefore, I value this segment at $1,096mm or $10.43 per share.

2) Life and Annuity + Corporate Segment

I valued these segments on a book value basis. PNX has shareholders equity of $2,384mm. I subtract goodwill of $880mm because almost all the goodwill relates to the Investment Management segment which was built through acquisitions. I also take out $327mm, the value of the venture capital portfolio and $100mm, my estimate of the equity in the Investment Mgmt. segment (a business that requires very little capital). That leaves book value of $1,077mm for these segments. I used a 0.8x P/B multiple because PNX’s cash ROE excluding venture capital was 4.4% in the last quarter. The biggest reason for this low return is the large closed block of participating life insurance policies. “Participating” means that most of the profitability goes to the policyholders through dividends, not to the insurer. This block represents 61% of invested assets and had an ROE of (3.8%) while the non-participating block had a 9.1% ROE. The company is not writing any more participating policies and targets an overall 8-10% cash ROE excluding venture capital by the end of 2003. This target is not very hard to achieve as I will explain below. Nonetheless, since the company is not earning its cost of capital, it is destroying value until the ROE improves. It therefore must be valued at a discount to book value. I think 0.8x book is appropriate, valuing these segments at $862mm or $8.21 per share.

2) Venture Capital Portfolio

On 3/31/01 the portfolio was split as follows: 34% VC early stage funds, 12% VC multi stage, 2% VC late stage, 39% LBO and 13% Other. Given the current outlook for VC and that this is not my area of expertise, I valued the $327mm portfolio at 0.8x for conservatism, or $2.49 per share.

3) Hidden Value

PNX has two investments carried at cost which have a significantly greater market value. A couple of years ago, the company sold its P&C brokerage business to Hilb Rogal & Hamilton Co. (HRH - $42.20) and retained 2.27mm shares in the company. These shares are carried at a cost of $49mm but have a market value of $96mm, for a delta of $47mm. PNX also owns 51mm shares in Aberdeen, a Scottish asset management company which trades on the London stock exchange (at 4.175 pounds x 1.4462 $/pound = $6.04 per share). The market value is $308mm while it is carried at a cost of $143mm, for a delta of $165mm. Adding these two deltas together yields an incremental $2.02 per share in value from marking these investments to market.

The parts sum up to a fair value of $23.15 per share today, using what I believe to be conservative assumptions. If you want to use your own valuation assumptions, the following sensitivities provide a good rule of thumb. Each 0.1x change in the P/B multiple for Life & Annuity + Corporate adds roughly $1.00 to fair value, and each 0.1% change in the AUM valuation of Investment Management adds about $0.50.

As a reality check, book value is $22.71. As a further reality check, Fox-Pitt Kelton estimates embedded value (EV) to be $21.85. EV is essentially the intrinsic value of an insurance company based solely on the policies in-force today and assumes no new business is ever written. It is composed of two parts: the statutory (tangible) equity in the company plus the present value of the future profits off the in-force policies. I won’t get into the details of how this is calculated..…the important thing is to use consistent assumptions across a group of life insurers and see where they trade relative to EV. Because PNX also has an asset management business, Fox-Pitt valued it at 1.7% of AUM (more conservative than my 2%) and added this value to the EV of the insurance business. Since EV does not include any value for future business written, a going concern life insurer should trade at a premium to EV. At 68% of EV, PNX is really a bargain. In addition, Fox-Pitt found that PNX is the only life insurer with a market cap greater than $1 billion trading at a discount to EV. The Price/EV of comparable companies is as follows (according to Fox-Pitt): MONY Group 107%, Protective Life 142%, MetLife 156%, John Hancock 163%. This is what Ben Graham meant when he wrote…..pay for today and get tomorrow for nothing. With PNX you get today for 68 cents on the dollar.

The following items can make for a prosperous tomorrow.

1) Solid position in a very attractive market.

PNX focuses exclusively on the high net worth market which is the sweet spot of the insurance industry. Lincoln National (LNC) likes to quote the following statistic in virtually all their investor presentations. The “super affluent” (defined as those with over $1 million in liquid assets and $4 million in net worth) make up 3% of U.S. households but generate 46% of the financial services industry’s profits. Despite its small relative size, PNX has an excellent reputation in this market. My firm competes with PNX in the managed accounts business (high net worth individual asset management). I spoke to three salespeople at my company and one external high net worth insurance agent. All had nothing but admiration for PNX. Comments included: “among the best at servicing,” “not aware of any weaknesses,” “they have every asset class covered,” “one of the blue chips of the mutuals.” Exceptional customer service and agent support were continually brought up. How does this small company out service its larger competitors, all of whom are aggressively targeting this attractive market? Focus. High net worth is all they do. By not being a common household name, Phoenix actually has an advantage in this market. I’ll paraphrase a comical comment a sell-side analyst made to me. “If you’re a multi-millionaire and you go to your financial advisor, you don’t want him to recommend Fidelity funds for you because the guy who mows your lawn is in Fidelity. You want something more exclusive.” (My apologies to anyone at Fidelity).

2) Strategic alliance with State Farm.

State Farm has 1.8 million high net worth households as policyholders, or 29% of high net worth households. They looked for a partner to market more sophisticated life and annuity products than their offerings into their customer base. State Farm put out an RFP, looked at 20 companies and selected Phoenix based on its breath of products targeting this market and distribution. Its logical to wonder whether PNX won the business on price. Well, after doing due diligence on PNX, State Farm committed to buying 10% of the IPO, and now owns 4.9% of PNX. If PNX bent over backwards on price, why would State Farm want to make an investment in this company? I think State Farm’s investment provides external validation as to the quality and competitive advantages of PNX. The State Farm deal can be substantial for PNX over time. Today it is being piloted in three markets, but longer-term this alliance can materially increase PNX’s growth rate.

3) Substantial excess capital

PNX has about $400 million in excess capital (one reason, but not the only one, why the ROE is so low). The company has not announced a share repurchase program yet, but on the last conference call the Chairman stated “over time, share repurchase will need to be an integral use of capital.” Excess capital represents 25% of PNX’s market cap.

4) Multiple opportunities to improve ROE.

PNX hired numerous wholesalers in its life & annuity and asset management segments in the months before its IPO. Therefore, its expense structure is bloated above and beyond the typically high cost structure of a mutual insurer by these currently unproductive wholesalers. As these guys increase their productivity and PNX takes costs out of its base, earnings growth and ROE should benefit. The ROE will also improve simply through the mix shift to non-participating policies and the run-off of the closed block. Finally, deploying the excess capital into share repurchase will enhance ROE. The P/B multiple of life insurers has a strong correlation to ROE, so as PNX improves its returns, its multiple should follow. As stated above, the company targets doubling its cash ROE excluding VC by the end of 2003.

5) EPS growth will accelerate next quarter simply by investing the IPO proceeds.

While PNX is cheap on a P/B, P/EV and sum-of-the-parts basis, it does not “look” like a bargain on a P/E basis. PNX reported Q2:01 operating cash earnings excluding VC (and a one-time benefit) of $0.18, or $0.72 annualized. I subtract the value of the VC portfolio ($3.11) from the stock price ($14.90) to put the P and E on the same basis. This yields an adjusted P/E ratio of 16.4x current annualized cash earnings. The most prevalent argument made by people who don’t like the stock is: “its not cheap on earnings.” Consider the following. PNX received the IPO proceeds two weeks before the close of Q2, therefore the investment income off this capital is not reflected in Q2 EPS. Net proceeds were $831mm. If you assume they invest at a 4% after-tax yield, that adds $0.32 per share to the Q2 run rate of $0.72, for $1.04 in normalized run-rate cash earnings. The adjusted cash P/E is now 11.3x. Morgan Stanley, the lead underwriter, estimates $1.07 in 2002 cash EPS excluding VC - just a 3% improvement over current run-rate earnings! This company has a bloated expense base and just signed a very meaningful strategic alliance with State Farm. There is a good chance that PNX significantly beats the current estimates. Nonetheless, the market is taking a wait and see attitude as the stock is trading below its $17.50 IPO price.

6) A highly attractive takeover target.

Almost every time I hear a financial services company talk about acquisitions they mention the high net worth area or asset management. PNX has both. Asset managers trade at a substantial premium to book value. At $14.90, PNX trades at 0.66x its book value of $22.71 and 1.04x its tangible book value (excluding goodwill) of $14.32. PNX could represent a cheap way to acquire $54 billion in AUM along with a pretty good life insurance business.

Risks

One risk is their asset management business is weighted toward growth and investment performance at some of their affiliates has been poor in recent periods. I’m not exactly rooting for growth to outperform value. Another is their fixed income portfolio has a 9% weighting in junk bonds vs. the industry average of 7%. However, some high quality insurers are even higher: John Hancock 14%, MetLife 10%. Also, as with all annuity and asset management companies, earnings are sensitive to fluctuations in the equity markets. In my view, these risks are well reflected in the current valuation.

Finally, what I find very compelling about PNX is how little downside there is. Let’s paint a negative scenario. Three years from now we find that management has executed very poorly and the ROE has not improved at all. There is actually a real-life example of this scenario. MONY Group (MNY), which demutualized in Nov. 1998, looks a lot like PNX. It’s a $1.8 billion market cap life and annuity company with a large VC portfolio. At the time of the IPO, MNY had a 6% ROE and a compelling story about how the ROE would improve. Now almost three years later, the ROE is still 6%. The amazing thing is MNY has outperformed the market since its IPO: up 17% vs. the S&P down 4%. The stock came public at 0.7x book value and now trades at 0.9x book. There aren’t many people that got wiped out investing in demutualizations. These things have a strange way of working out.

Catalyst

1) 55% upside to fair value today, using conservative assumptions.
2) EPS growth will accelerate next quarter simply by investing the IPO proceeds.
3) Strategic alliance with State Farm could significantly increase PNX’s long-term growth rate.
4) Excess capital equates to 25% of the market cap; some portion should go towards share repurchase.
5) Multiple opportunities to improve ROE. PNX targets doubling its ROE in two years.
6) Longer-term, PNX is a highly attractive takeover target.