Overview - I am recommending purchase of United American Indemnity (INDM) at a price of $21.20. I believe there is a better than 50% chance that the company is acquired for a large premium in the next 12 months. Baring that the stock will likely see its earnings and price/book multiple expand. The company is currently trading at a large discount to its peers and its ROE is depressed due to a large reinsurance receivable asset as a percent of equity. As this ratio declines over the next year I expect the stock’s price/book will increase and capital will be freed up. EPS growth will accelerate as this freed up capital will be directed to writing and cross selling new products across its client base as well as ramping up sales of 3^rd party reinsurance.

I first recommended this stock on VIC on 11/22/05 at $18.98 with a one year target price of $25. The stock made it to $24.60 by this April but has since sold off. I am again recommending the stock due to 1) The recent decline in the stock despite no negative news and a pretty good 2Q06 result, 2) We are now likely much closer to a sale of the company, 3) The risk of executing the big merger integration has passed, 4) Book value per share has increased , 5) peer stocks have outperformed over the last 12 months and 6) the net reinsurance receivable/equity ratio has moved down significantly.

 

Basic Business - INDM is a specialty insurance company in the Excess & Surplus (E&S) lines space. These niche products are generally unregulated and priced by the market rather than State insurance regulators. INDM writes mostly short-tail policies in areas including a) professional E&O insurance for Chiropractors, Lawyers, Public Officials, etc. b) Business umbrella/excess coverage policies, c) liquor liability, d) vacant properties and e) equine mortality. INDM has a very good underwriting record and history of book value growth.

 

These E&S businesses demand specialized underwriting skills and knowledge. Rates of return are generally higher, though the volume of business is smaller than for ‘standard lines’ such as homesowners’, auto and wind damage.

 

Ownership – INDM is 59% owned by Fox Paine Capital (www.foxpaine.com) which is a buyout firm run by Saul Fox and Dexter Paine who were former partners at KKR prior to founding their own firm in 1997. The firm has made several successful investments in assorted industries and a perusal of their website shows a steady drumbeat of sales of its portfolio companies at hefty premiums. Saul Fox currently is the acting head of INDM as Chairman of the Board. The three operating unit heads and the CFO report directly to him. The President has resigned and there is no current search for a replacement nor for a CEO.

 

History: INDM is the result of the merger of United National (Fox Paine’s vehicle) and Penn American Group back in January, 2005 and the combined company is 59% owned by Fox Paine Capital. Both companies had similar business lines but Penn American clients were more rural and United National’s were more urban in general. The two companies have been put together at a slow and steady pace. In the first year post-deal the focus was on cutting redundant back-office savings which has led to the expense ratio falling a couple of points to 31% (with a bit more in savings left to be achieved). In January, 2006 they merged the two operating companies. By moving to one platform INDM is now cross-selling formerly non-overlapping Penn American business lines to its United American agency relationships and visa versa. The main impact of this change will be seen in the big January renewal season in 1Q07. Now that the merger is mostly complete, one of the two day-to-day operating managers is no longer needed. This is why the President, Joe Morris is on his way out (no surprise he was the executive from the former Penn America).

 

Underwriting Skill: At the end of the day you make or lose money in the P&C Insurance business through good underwriting and growing book value.

 

 

As you can see from the above chart, INDM has grown its Book value every quarter since it had its IPO at $17 per share in December, 2003. The most impressive part of this track record is not only its consistency but also that the company grew its BVPS in 3Q05 and 4Q05 (though only slightly) when hurricanes Katrina and Rita led to massive losses and declines in book across almost every other major P&C company in the country.

 

Reinsurance Receivable: At the time of the IPO the P/B on INDM settled well below its larger peers E&S writers due to a large net reinsurance receivable on the balance sheet which totaled almost 3X GAAP Equity vs. an average ratio of +/-80%. Many investors worried that this elevated receivable risk would hold back the stock’s P/B ratio until it fell to less than 1X GAAP Equity.

 

To ‘clean up’ the balance sheet, INDM has done the following:

 

1) Upgraded its reinsurance partners over time. Over 95% of the reinsurance receivable now owed is from firms that are rated at A, A+ or A++ by A.M. Best.

 

2) Merged United American with Penn National Group which had a much lower Receivable/GAAP Equity ratio.

 

3) Secured irrevocable collateral for almost ½ the gross receivable from reinsurers to reduce the net receivable number.

 

4) Retaining earnings faster than the growth of the reinsurance receivable.

 

5) Switch reinsurance buying practices to only ceding on an excess of loss basis (rather than any proportion of loss contracts).

 

The receivable ratio has fallen consistently each quarter and is now down to 80% of GAAP Equity. Management expects that the ratio will come down at least another 10% over the next year as the receivables pay off and book value grows. As the receivable pays down, INDM will not have to secure as much collateral from its reinsurers. Securing this collateral currently costs INDM around $3M per year resulting in about a 5% drop in annual EPS.

 

Management realizes that there is “great value in reducing this ratio further” in terms of both EPS and P/B ratio on the shares.

 

Business Outlook: Prices have basically stabilized and management expects them to stay relatively flat on average through the major January renewal season (I have heard similar forecasts from others in the industry). Top line growth in 2007 will primarily come from the following:

 

1) Typical increase in writings from current clients due to an expanding economy.

 

2) Cross selling some Penn America specific policies lines through the old United American network and visa versa.

 

3) Writing up to $50M in new 3^rd party non-wind risk reinsurance through INDM’s Bermuda operation.

 

4) The ability to lever up the balance sheet over time as the receivable/equity ratio is reduced.

 

Peer Valuations: On a Price/Book ratio, INDM is cheaper than both its larger and smaller peers in the E&S space despite having an average ROE and its stock has dramatically underperformed the average of other E&S insurers +41% appreciation over the last 12 months –

 

 

1) Buyout: Fox Paine has historically held its investments from 4-6 years. Next September is its 4 year anniversary owning a controlling interest in INDM. The company does not have a CEO or a President. The Fox Paine website talks about the strategy behind their investments being to increase the value of their properties through cost and revenue enhancements and then harvesting of gains through asset sales. INDM is ripe.

 

The majority of savings from the merger with Penn National Group have already taken place and the net reinsurance receivable has been brought down to a level in line with peers. Larger players such as MKL and BER have done numerous deals in the E&S space in the past and I can see them paying as much as 1.7X to 1.8X P/B for INDM in a deal which would result in a return greater than 40%. Such a deal would be immediately accretive to MKL or BER’s book value even before cost savings are taken into account. Large insurance companies focused on ‘standard lines’ companies such as Chubb (CB) or St. Paul (STA) or AIG (AIG) have also bought smaller specialty players in the past. Their P/B ratios are a bit lower than the large E&S players but they also could pay a healthy premium for INDM and make a deal work.

 

INDM is growing its book value per share by 10-12% per year (or additional Katrina-like hurricane seasons = only 7-8% BVPS growth). Assuming that the company is sold for a premium to book of 1.5X-1.9X, the takeover value of the company is actually growing at 15-23% per year. (10%*1.5X to 12%*1.9X)

 

2) Higher Revenue Growth/ Rising ROE: INDM is just starting to ramp up its cross selling initiatives in the States as well as its new writings of 3^rd party offshore reinsurance. As the reinsurance receivable continues to shrink as a percentage of equity, the company will be able to increase its gearing and its ROE. If INDM is able to execute on its strategy, EPS will likely exceed consensus expectations

 

3) P/B Expansion: INDM trades at a discount to both larger and smaller peers despite an average ROE (INDM = 1.2X P/B, Peers = 1.9X). In addition, the stock has underperformed its peers over the last 12 months (+18% vs. +41%) despite excellent underwriting results and the successful integration of its merger with Penn National. Now that the reinsurance receivable/GAAP equity ratio has come down to a more reasonable 80%, and it will continue to decline, it is likely we will see INDM trade to a peer average P/B over the next 12 months (if it is not sold).

 

 If, over the next 12 months, United American traded up to ‘only’ the P/B of the next two cheapest E&S insurers at 1.5X P/B (PROS + EMCI) and BVPS grows by 10% the stock would appreciate to $29.75 for a one year return of +38%. If, on the other hand, INDM is able to trade to the average 1.9X P/B of its peers and it is able to grow its BVPS by 12% the stock will be $38.33 a year from now for a 78% return.