Who says persistency doesn’t pay off? After being poked and prodded by The Anal_yst for the past two years, I have capitulated. Below, I humbly submit my first foray into the blogosphere. Insurance – aside from the trials and tribulations of AIG/Chartis/AIG – is an often overlooked subsector of the Financial Industry. As such, I will attempt to provide periodic topics for my enjoyment and your edification.
Why does the owner of fast food chains want to buy a middling insurance company domiciled in an unfriendly state?
First, it is important to understand the would-be acquirer – Biglari Holdings (NYSE: BH). Based in San Antonio, Texas, BH has total equity of $249 million and a market capitalisation of more than twice that amount. Biglari views itself as a “liquidity provider.” Much like Berkshire Hathaway (NYSE: BRK.A) owns a number of companies both public and private, so too does BH. However, unlike Mr. Buffett’s company, Biglari generates the bulk of its earnings from the restaurant industry, specifically, Steak and Shake and Western Sizzlin. BH has cash and investments on its balance sheet of $80 million. This is invested by management through its wholly owned hedge fund (which it bought from its Chairman for $1). It is also interesting to note that BH has executed a number of derivative contracts. The parallel being Berkshire’s large short position in S&P 500 puts. Management’s stated goal is to “achieve high risk-adjusted returns” by “taking advantage of mispricing risk.” Further, management states that they frequently find “underperforming, undermanged, and undervalued companies because they afford better opportunities or outsized gains.”
Another point of interest is the incentive compensation package for the Company’s Chairman; who, by the way, owns approximately 15% of the shares. The agreement gives the Chairman 25% of the increase in adjusted book value exceeding a 6% hurdle rate. He must then use 30% of the incentive comp to purchase more shares in the company. The upside has been capped at $10 million. On the surface, the cap seems counterproductive. However, one could argue that it prevents management from taking on excessive risk.
The object of Biglari’s desire is Fremont Michigan InsuraCorp, Inc. (OTC: FMMH). Fremont is a Michigan only property and casualty (P&C) insurance carrier tracing its roots back to 1876. FMMH insures homes, farms and small businesses in the state. A review of their third quarter earnings release shows that the company’s primary operations – underwriting insurance – is unprofitable.* The year-to-date combined ratio for FMMH was 102.8%. This means that every $1 the company took in as premium, it paid out $1.03 in claims. While this does not necessarily ring the death knell for an insurance company, it does mean that the losses from underwriting need to be made up by profitably investing the “float.” Most people are familiar with the term because the Oracle of Omaha has often spoken about this topic. FMMH was able to report earnings of $2 million on revenues of $48 million for the 9 months ended September 30 because of positive investment results. Total investments on the company’s balance sheet totaled $76 million at the end of the third quarter. Of that amount, approximately 22% of the portfolio was in equities. This is highly unusual for a P&C company.
Typically, insurance carriers match their assets to their liabilities. This simply means that the investment portfolio should have an average duration equal to the payment of claims to insureds. For most P&C companies, this duration is equal to 3-4 years. Moreover, equities are rarely seen in investment portfolios of P&C companies because, despite their liquidity, they tend to be more risky.** However, investors pay management of insurance companies to take underwriting risk, not investing risk. With short term rates at historic lows and a money losing underwriting team, FMMH has no choice but to take on more risk with its investments.
It is worth noting that Fremont is no stranger to hostile offers, in 2008 it was the target of an activist investor who ultimately was unable to gain any traction in getting a nominee on the company’s Board. At that time the stock was trading at in the $17 – $19 range. The activist pegged a buyout price of $31 or 1.4x the then current book value per share (BVPS). That multiple implied a takeover by a “strategic buyer” who could provide economies of scale (I’ll refrain from using the word “synergies”). FMMH’s current market cap of $50 million is largely a result of the bear hug – see nearby stock chart. Prior to BH’s offer for $29 a share, Fremont was trading in a range of $19 – $21. The pre-offer valuation was approximately 75% of book value – more or less in line with other small publicly traded insurance companies. The current offer of $31 a share is 1.12x the most recent BVPS. At the time of biglari’s initial approach, FMMH fit the characteristics highlighted in the Chairman’s Letter – underperforming and, more significantly, undervalued.
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This leads us back to the original question – why would biglari want to buy Freemont? There would be no economies of scale. BH has no prior experience in insurance. Not to mention, insurance companies, for the most part have struggled to generate double digit returns on equity. For its part, FMMH has produced lackluster returns. In fact, despite consistent prodding by activists, FMMH’s results remain sub-par. This takes us back to the Berkshire analogy. An acquisition would give BH control of insurance company’s float – effectively doubling its current investment portfolio. When bigger is often seen as better, an acquisition would be one of the fastest ways to grow BH’s asset base. Given the current valuation at 2x book value and 25x earnings, it’s clear that an incremental dollar of earnings goes a long way in growing Biglari’s stock price.
However, in the rough and tumble world of M&A, ego’s often get in the way practical business sense. At current levels, valuation makes more sense for a strategic investor not a financial one. The landscape is littered with private equity firms (“financial buyers”) with insurance investments that have stayed in their portfolios long past their “sell by” date. Moreover, of the comparably sized insurers (less than $60 million market cap), only 2 trade at or above book value and the average multiple is 0.67x book. Case in point, 21st Century Holding (NASD: TCHC) has an investment portfolio of $80 million and a book value of $62 million. Yet TCHC currently trades for less than half of its stated book value.
In my view, most deals start out good, it’s the price paid that turns them bad. At this point, it would be better for BH to walk away and direct its resources to other opportunities. FMMH management has done a good job with it’s do nothing defence. The stock has more than doubled from its 2009 low of $12.25. However, it’s quite possible that the stock languishes from here if BH walks away. After all, how many professional money managers will pay attention to a $50 million market cap company? Given all of the attention, perhaps it’s time to hire an investment banker to find a strategic buyer to get a “full price” for the business.
*It should be noted that the P&C sector is currently experiencing what is generally referred to as a “soft pricing cycle.” This means that premium rates are too low to generate adequate risk adjusted returns. Soft pricing occurs when there is too much capital in the industry, primarily due to a lack of major events such as hurricanes and earthquakes. However, companies should still seek to make underwriting profits – even if it means shrinking the top line.
**Insurance companies are subject to a Risk Based Capital (RBC) ratio which has a role in determining an insurance carrier’s rating. All else being equal, higher equity exposure tends to lower the RBC ratio.