Description

Not All Good Businesses are Big Businesses

The best businesses, as we all know, deliver high returns on capital and because of that the market tends to reward them with high multiples of earnings.  Most of the time, though not always, these very good business are quite large...there are obvious companies that come to mind like Coca-Cola, American Express and Moody's (at least it was for a period of time).  It is in the "not always" category that we are particularly interested in here.  Some companies, though small and exploiting a narrow niche, can be very good businesses.  To your attention I bring one such company, The Marketing Alliance (MAAL.PK).

To be sure the company is perhaps more suited for personal investment than a professionally managed fund, but to those with a small capital base it provides the opportunity to invest in a very good business at a very good price.  Shares of The Marketing Alliance (TMA) are traded in the over-the-counter Pink Sheets market under the symbol MAAL.  The company is fully reporting and audited.  Now headquartered in St. Louis, Missouri the company aggregates a large group of small, independent insurance managing general agents who typically offer life insurance and annuities.  These small agents, unable to effectively negotiate with the large insurance carriers, turn to TMA to aggregate their business with that of other small agents to garner better commissions from the insurance carriers.  The insurance carriers enjoy the relationship as it conducts business with a single master agent, TMA.  TMA also provides marketing and technology support to the agents.  In exchange for the pooling of production and support services, the company earns a portion of the commissions generated by its network of managing general agents. 

The business model delivers extremely high returns on capital and to protect those returns TMA benefits from a network effect and enjoys, what I believe, is a reasonable moat.  The company essentially manages a network of small agents.  At its essence, that is the business-the network.  The bargaining power created by the pooled production of a large network enables TMA to negotiate directly with insurance carriers for better terms than any individual agent could achieve on its own. As each agent is added to the network and as each agent grows its business, TMA is in a better position to negotiate on the network's behalf with the insurance carriers.  Though some of the benefits of this increased leverage return to the agent, TMA also benefits.  (Interestingly, the company benefits to a greater degree as it adds smaller agents as opposed to less profitable larger agents.  So the key to the businesses model is the appropriate mix of large and small agents.) 

The company's moat comes from this network of small agents.  It has successfully built-up a captive agency base, something that would take years to develop and scale to achieve.  From an agent's perspective it is usually not attractive to leave one network for a smaller network or start-up network unless the agent is big enough to demand more from that particular aggregator.  Of course that may not be attractive to the aggregator.  Additionally, because of the demands of automation pushed by the insurance carriers, TMA has integrated its technology and systems with that of the insurance carriers and its agents.  Agents prefer not to and often cannot make in a cost effective manner the investments necessary to accomplish this.  This has the effect of locking the agent into the network creating a fairly captive agent.

The operating history of TMA began to change when the Board of Directors hired Tim Klusas as President in 2005.  A young guy in his early 30's at the time, Klusas had an M&A and operations improvement background in a large organization.  He has turned TMA from a small band of associated agents into an extremely profitable professionally managed business.  Provided below is a five year snap-shot of the company's income statement:

Klusas has done a fine job, as operating income has improved from 9.6% of sales in 2004 to greater than 15% of sales in the latest twelve months.  As the company has grown and improved operations it has utilized additional unused capacity and has improved its negotiating power with carriers.  While I do not see further substantial improvement in the operating margin, Klusas has positioned the company to expand its service offerings, grow its agent network and in turn grow the top line.  As you might imagine, his efforts in this regard over the last couple of years have been stymied by the financial crisis.  Buying behavior of life insurance, partly driven by the carriers themselves, was altered and buying behavior for annuities in the current low interest rate environment has also been hampered.

As previously mentioned the company's return on equity and capital shows just how good the business is.  Below is a chart which shows the calculations.  Returns on average equity look good, though perhaps not great from a consolidated perspective.  They range from less than 9% to nearly 40% over the last five years.  However, it is when you exclude the company's excess capital that the strength of the business is really seen.  Excluding cash and investments of 3% of the company's revenues which is needed to run the businesses (with a $500,000 floor), the company generated a return on equity in excess of 100% in its latest fiscal year ended 3/31/10.

The returns on equity at TMA are so high because it obviously takes few fixed assets to run the business.  As mentioned, the business is predominately the intangible "network."  In addition, it is an organization that, since the arrival of Klusas, is now focused continually on cost control.  If you define a good business as one with a defendable moat and high returns on capital, TMA seems to be such a company.  Though not well known at this point, the founders and the Klusas team have built a remarkable operation.

Equally important to the thesis is the company's balance sheet and dividend policy.  The company sports a balance sheet with significant excess capital.  It is an asset-light business as exhibited by the 9/30/10 balance sheet:

The company has paid out an annual dividend for a number of years now, as indicated by the table below.  Typically the once a year dividend has an ex dividend date that is sometime in the late Fall and at the current price, the company yields 3.89% based on last year's dividend.  There is every reason to believe that the dividend will continue to increase.  The table also reflects how the business has transitioned since the early 2000's and Klusas' arrival.   

Also, the company has been buying back stock.  Since the first calendar quarter of 2007, the company has repurchased over 6.5% of its shares outstanding at highly advantageous prices.  While not a huge number, it is significant given the illiquid nature of the stock. 

The future performance of the business seems bright.  Over the last few years the company has accomplished two important business initiatives.  First it has added the distribution of annuities to its life products, which has similar distribution overlap.  Also, it has added a number of additional insurance carriers that broadens the scope of products the company's agents can provide customers.  New carrier additions tend to take as much as 18 to 24 months to really impact the business as agents must learn the ins and outs of the carrier and its product before selling them to their customers.  There are additional horizontal and vertical expansion opportunities that the company sees as opportunities to exploit in the future (recent new hires as noted below may indicate additional effort in this area).

Risks

Potential for Improper Allocation of Capital

A crucial part of the thesis is that TMA has significant excess capital.  TMA could pursue sub-optimal endeavors with that capital.  As can be gleaned from the balance sheet a significant portion of this excess capital is in investments, which I understand to be primarily equity based.  These investments represent about 56% of my excess capital estimate.  This income statement shows the history of how these investments has performed.  As you might expect during the market turmoil, the portfolio did not perform well.  Since the fiscal year ended in March of 2004, the company's realized and unrealized gains from investments is slightly positive.  Also note that the balance sheet is from September 30, which was before the recent run in the market. 

Aging Agent Base

The average age of the agent base is over 50 and the number of new young insurance agents is not growing.  This is a problem that the entire life insurance business is dealing with and a simple Google search can locate many articles on the topic.  The implications for this are a bit uncertain.  On the one hand an aging and potentially declining industry base of independent agents could be positive for bargaining position of a network like TMA, while on the other perhaps this ushers in changes in the distribution model.

Continued Decline in the Number of Insurance Policies Written

The following chart, which I haven't updated through 2010 shows a bit of what the industry is facing.  The information is taken from the Life Fact Book published by the American Council of Life Insurers.  Basically the number of new life policies written has declined significantly over time, from over 17,000 in 1980 to less than 11,000 in 2007.  Premiums have not declined in the industry as much as this would seem to suggest given rising face values for policies. 

As dire as the individual policies written numbers appear, and to be sure it is not a great long-term trend for the industry, group policies since 1980 have risen.  I've not included that information here for the sake of space but would encourage interested individuals to take a look.  Also of note is the great rise in annuities over the last three decades.  This makes complete sense of TMA's decision to move into annuity distribution a few years ago.  While a small portion of the company's current business, it seems to have been a prudent decision.

Disintermediation by Life Carriers

I really have no insight into how big of a threat this is.  Could major carriers decide to build out a sales force or market directly to consumers over the internet?  It is certainly possible, as commissions are a big expense.   I think the problem lies in the nature of life insurance as a complex product that the consumer wants to be certain will provide for their intentions when it is needed.  This may reduce the effectiveness of distributing over the internet (see below).

Internet Distribution

Internet distribution of life insurance is perhaps a risk and opportunity for TMA.  While it appears that distribution via the internet has not advanced much beyond lead generation for agents, this could be a long-term risk.  What is interesting is that TMA works on behalf of internet based distributors.  The problem with internet distribution is that a life policy, especially a complex high face value policy, is not like binding an auto policy.  The individual health profile of the potential insured is highly critical and requires documentation beyond just what the potential insured says.  This brings physicals, doctors and tests into play.  The back office support of TMA supports this function highly efficiently given its scale. 

Dependence on Klusas

Klusas has proved to be a sound choice by the Board several years ago.  In a small company like TMA, the influence of such a leader cannot be understated.  While conversations with him suggest he enjoys what he is doing and where he is doing it, the loss of Klusas would not be a positive.

Additional Items of Note

Potential Float in Business

While this means less in a low interest rate environment like we are in, this could be a substantial characteristic of the business if rates rise significantly.  The company's liabilities are primarily commissions due to its agents which are accrued throughout the year until paid.  So essentially these liabilities are non-interest bearing long term payables.  A consistently rising commission liability might imply some permanent level of float. 

Recent Company Personnel Additions

In the company's recent press release on the quarter ended in September, it noted two new hires.  One is for the position of Strategic Planning & Quality, which I understand will be a position that focuses exclusively on growing the agent base and reach of the business into non-traditional distribution channels which have been growing (banks, financial planners especially).  The other hire is for a position titled Director of Corporate Development which will "search for ways for TMA to efficiently deploy capital around our core business."  Both hires seem significant in relation to the company's ability to put excess capital to work and to focus on growing the business.

Reporting

TMA of course is not registered with the SEC.  It currently provides quarterly press releases with a significant lag on the business with a balance sheet and income statement.  In those releases it does not provide notes to the financials or a cash flow statement.  I believe that the company recognizes the limitations that its reporting provides the market and am hopeful that this might improve in the future.

The company is audited by UHY, LLP which is the 20^th largest world-wide independent accounting association.  According to CapitalIQ, UHY audits 74 public companies in the US, the largest of which is Gulfmark Offshore at near $1 billion in market cap.

Valuation

To put the discussion of the company's recent financial performance and the quality of the business in perspective, the following are some summary statistics on the capitalization and financials: 

* Note: NOPAT in this situation appears to be the most appropriate measure of the company's operation as net income has and will likely continue to be effected by non-operating items (investment portfolio).

To summarize my valuation thoughts, I think the company is worth nearly $15.00 per share even if it continues to trade on the Pink Sheets. 

Comparables

There are really no direct comparable public companies.  If you expand slightly the definition of comparable you can start to include other insurance brokers and financial products distributors.  A selection is provided:

If MAAL was trading on an exchange I believe the company would deserve a strong multiple given the quality and nature of the business, perhaps in excess of 15x.  Below I provide the rationale behind my belief that the company is worth nearly $15.00 per share, which is principally driven by a 12x base multiple on NOPAT per share plus excess capital per share.

Catalyst