“While knowing how to value businesses is essential for investment success, the first and perhaps most important step in the investment process is knowing where to look for opportunities.”
Seth Klarman
“If you spend your energies looking for and analyzing situations not closely followed by other informed investors, your chance of finding bargains greatly increases – the trick is locating those opportunities.”
Joel Greenblatt
Thesis:
An investment in the Penn Miller Holding Company (PMIC, Financial), at or around the current price, offers bargain-hunting investors the chance to purchase a classic low-risk, high-return special situation that possesses nearly all of the qualities we look for in a great investment. Of particular note about PMIC is: (1) a low valuation (both absolute and relative to peers), (2) a good, fully-incentivized management team, (3) near- to medium-term operating momentum, (4) a promising long-term business model, and (5) a variety of internal and external catalysts that should help bring about the convergence between price and value.
Given the company’s recent conversion from a mutual to a publicly-traded holding company (and the unique underlying dynamic/implications of such a transition), and the fact that it’s in a cyclical business that is operating at a cyclical trough, we think it is reasonable to believe that Penn’s underlying operating performance is poised to significantly improve going forward. The bottom line here is that as the insurance market normalizes and the company’s newfound operating leverage begins to kick in, the market will come to its senses and award this undiscovered quality company with a more appropriate multiple on much higher profits at some point in the coming months and years – driving returns of potentially 100%+ over the next 2-3 years with limited downside risk.
Brief Business Description:
The Penn Miller Holding Company is a regional property and casualty insurance company that originally opened its doors in 1887 in Huntington, Pennsylvania. Its primary business is its agribusiness segment (60% of premiums), which tends to cover middlemen operations and not product producers or farms (i.e., the company generally does not insure farms or farming operations). Its commercial segment (40% of premiums) typically writes business owners packages for small businesses.
Penn Millers currently has license to operate in 39 states; and sells its agricultural insurance products in 33 states and commercial insurance products in 8 states. The company is headquartered in Wilkes-Barre, Pennsylvania.
Mutual Conversions – A Secret Hiding Place of Stock Market Profits:
In order to understand why mutual conversions offer such an attractive area for uncovering inefficiently priced opportunities (and hence tend to be a secret hiding place of stock market profits), it is useful to quickly walk through the mechanics of a mutual conversion in order to more fully understand why this is so.
When a mutual insurance company converts, it goes from being owned by its policyholders to being owned by a holding company which, in turn, is owned by the general public. The conversion process usually starts with a subscription offering, through which the policyholders, employees, officers, and directors of the institution in question are given the right to buy shares, typically for $10 each, in the new holding company. If there are any shares remaining after the subscription offering (and often there are not) the remaining shares are usually then offered first to people in the local communities that the insurance company serves, and then to the general public.
The key aspect for investors to understand here is that not only do shareholders of the newly public company have a full claim on the IPO proceeds (as is typical), they also receive a claim on all the pre-conversion market value at no cost. Unlike any other type of initial public offering, in a mutual/thrift conversion there are no prior shareholders; all of the shares in the institution that will be outstanding after the offering are issued and sold on the conversion, so the entire existing value, as well as the cash raised in the recent IPO, will belong to the post- conversion shareholders. If you’re unfamiliar with mutual/thrift conversion, you may want to go ahead and re-read this paragraph one more time
.
Again, the conversion proceeds are added to the pre-existing capital of the institution, which is indirectly handed to the new shareholders without cost to them. When describing the favorable arithmetic of thrift conversions and the reasons why investing in thrift conversions can offer such compelling investment opportunities for bargain hunting investors, Seth Klarman stated that “In a real sense, investors in a thrift conversion are buying their own money and getting the preexisting capital in the thrift for free.” Peter Lynch put it a little differently, once remarking that from the perspective of the IPO investor, this was equivalent to buying a house, moving in, and finding the seller had left the sale proceeds in the house for the buyer to keep. Indeed!
In Penn’s case, investors who participated in the offering on October 16, 2009, (and/or purchased the company post IPO) essentially paid roughly $50m for 1) $50M ($46.2M net) in newly raised cash, and 2) Penn’s $56.5m in existing equity. In other words, investors got their investment back immediately with Penn’s existing shareholder’s equity and insurance operations thrown in for free. Pretty good deal, no?
Why is it Mispriced?
Penn is an obscure, under-appreciated micro-cap that (1) just recently became public and hence is not covered by Wall Street, (2) has been facing both company specific and industry wide problems over the last few years, and (3) has a recent history of mediocre operating performance. Taken together, these issues/concerns have not only temporarily depressed results, but more importantly are masking what we believe is an impressive transformation in the company’s core business and future business prospects (offering yet another classic example of the market mis-pricing a business due to its inability to see past short-term cyclical and operational challenges due to its myopic fixation on the rear view).
Additionally, any time the future doesn’t give a particularly good view of what the prospective performance of a business is likely to be, there is an outsized chance the market will mis-price the opportunity in question. Typically, such situations are created when a business is in the midst of a major change in corporate organization and/or capital structure, and where the implications of the changes are not well understood. The conversion of Penn from a mutual to a publicly traded company late last year provides a perfect example of this phenomenon, as the implications of the conversion (and the underlying financial dynamics associated with it) are still unknown and/or remain misunderstood by most market participants.
To reiterate, Penn’s current mis-pricing is due to a recent history of relatively lackluster results and a combined ratio that appears superficially worse than it is. Thankfully, both of these trends are in the process of reversing. Additionally, the company has experienced a confluence of negative external events that, taken together, provided a near perfect storm of operational headwinds, such as (1) a cyclical recession in the insurance industry, (2) compressed short-term interest rates, and (3) a variety of operational efficiency and restructuring initiatives that are just now beginning to bear fruit.
The Rearview:
(Note – The following conclusions are substantiated by the Penn Miller corporate overview presentation, 10k’s, etc., which are attached.)
Considering the 35% discount to book, risk-averse investors need to get comfortable with the fact that PMIC’s operations have positive value and that the current price is not depressed for some unforeseen/undisclosed fundamental business reason. In order to do that, they must ask (and satisfactorily answer) three basic questions:
(1)How good has management been at pricing policies historically?
(2)How adequate has its loss estimates and loss reserves been?
(3)How well has it invested its float (have they invested intelligently)?
In regards to the first question, a look at the company’s combined ratios doesn’t inspire much confidence, at least at first glance, as it has been consistently north of 100 for the last few years. A deeper analysis, however, reveals that things aren’t quite as bad as they seem as (A) most of the losses of the last few years were due to the poor performance of a couple of lines within its commercial segment, all of which have since been discontinued, and (B) the company will be able to significantly reduce the amount of reinsurance they purchase going forward, which has been a considerable drag on results in recent years (and artificially inflated Penn’s combined ratio in the process). (pg.26, investor presentation)
Importantly, if you back out the cost of the “stop loss” reinsurance contract and the results from the unprofitable (and now discontinued) commercial lines, and further assume that they can continue to profitably underwrite their remaining lines in both segments (all reasonable assumptions in our opinion), then a properly adjusted analysis of the rear view implies that Penn would be consistently profitable on a going forward basis. There is obviously considerable room for improvement here, and the fact that Penn could have been marginally profitable is nothing to get excited about in and of itself. Regardless, we think the company’s underwriting performance should be considerably better in the future than a historical examination outlined above would suggest (more on this later). (pg. 29, investor presentation)
In regards to the second question addressing management’s history of being conservative in its reserving policies and loss estimates, our analysis would indicate that they have had strong success in this regard. This further bolsters our conviction in management and the value of the company’s operations, and more importantly minimizes our fear of experiencing the type of nasty surprises (read blowups) that are so common with undisciplined insurers. Our multi-year analysis shows that PMIC has enjoyed over $8 million in net favorable reserve developments over the last four years alone (10K pg F-34). So again, the historical performance of their policies suggests that management has done a more than adequate job of estimating its loss estimates and loan reserves accurately.
Looking at the third question (whether or not management has a history of intelligently managing their float), our analysis yielded positive results yet again. Taking a look at how the portfolio performed beginning in 2008 through today is helpful in thinking about this issue (as it provides a great stress test, so to speak). With that said, we feel that the fact that most of the losses they experienced in their portfolio have since reversed themselves, and that the company didn’t own any toxic waste (i.e., RMBS, CMBS, etc.), is a testament to their conservative nature. If we fast forward to today, we see more of the same, as Penn’s investment portfolio is primarily comprised of high-quality corporate, government, and municipal bonds with relatively short durations. Over 96% of Penn’s investment portfolio is rated ‘A’ or better by Standard & Poor’s, and the average effective duration of the portfolio is 3.4 years (see pg 19 of 10K). We like this, and believe it provides the company with the flexibility to both take advantage of changing market conditions and eventually, a rise in interest rates.
Again, for a variety of reasons we feel that the company’s present positioning is both prudent and wise. After all, why stretch for yield or extend duration in today’s uncertain, low interest rate environment? Management’s emphasis on shorter duration, higher quality securities reveals a team that is artfully balancing downside protection with upside optionality, something we like very much. Keep in mind that, by owning a high quality portfolio of securities, Penn’s management has gone a long way toward ensuring that their balance sheet will remain fortress-like and intact under nearly any scenario short of Armageddon. Also, by simultaneously insisting on short-duration assets with nearer term maturities, they ensure that they will remain flexible enough to immediately react, as well as capitalize on, a rising rate environment (for the most part). Again, we believe rising interest rates at some point over the next 3+ years is a near certainty – It’s not a question of if they rise, just when, how fast and how far! The bottom line here is that, looking out a few years, PMIC’s investment portfolio is not only conservative, but perfectly positioned to do well in pretty much any environment.
Operations and Levers for Improvement:
Operations
Penn Miller has 3 separate “earnings engines,” so to speak:
Agribusiness Segment – A specialized insurance company with a strong competitive position in one of the more attractive niche markets in the insurance industry today (primarily due to its attractive long-term fundamentals, limited competition, improving pricing outlook and substantial opportunity for profitable growth going forward). Better yet, Penn in is perfectly positioned to capitalize on various expansion opportunities, making an already strong competitive position meaningfully stronger in the near- to medium-term. (pg. 15, investor presentation)
The agribusiness segment usually covers manufacturers, processors, and distributors of products in the agricultural industry, and focuses primarily on fire and allied lines, inland marine, general liability, commercial automobile workers compensation, and umbrella liability insurance. For example, the company typically markets to businesses such as grain and storage elevators, flour mills, livestock feed manufacturers, fertilizer blending and application, cotton gins, livestock feed lots, mushroom growers, farm supply stores, produce packing, and seed merchants. This segment currently represents roughly 60% of written premiums.
Some historical context helps in understanding why we are excited about Penn’s future prospects in Agribusiness. First, Zurich attempted to try and dominate the industry earlier this decade, which ended up giving way to an industry wide pricing war. As always, huge losses resulted and Zurich ended up exiting the industry (as did other weaker players). As the third largest player, we think there is a good chance Penn benefits materially from this shakeout, and the improving pricing outlook that is the result of it, going forward.
Commercial Business Segment – A commercial business insurance company that is currently in the midst of an operational restructuring/turnaround, and is in the process of transitioning from a generalist insurer of small business to a specialist focused on select industries for both small and middle market customers. Going forward, this segment will share a niche strategy that is identical to the Ag segment, namely to identify discrete underwriting risks where competition is limited and they can add value through personal service. It is too early to draw any definite conclusions here about how successful this turnaround will be, but we think it’s a smart move and that the chances of success are good. (pg. 18, investor presentation)
The segment typically provides insurance coverage primarily to middle-market commercial businesses. They target select low- to medium-hazard businesses such as retailers (including beverage stores, floor covering stores, florists, grocery stores, office equipment and supplies stores, dry cleaners, printers, and shopping centers), hospitality (such as restaurants and hotels), artisan contractor businesses (such as electrical, plumbing, and landscaping), professional services (such as accountants, insurance agencies, medical offices, and optometrists), office buildings, and select light manufacturing and wholesale businesses. The commercial segment’s primary product is their “solutions” business owner’s policy, which covers major property and liability exposures, crime, and business interruption, utilizing a simplified ratings program (other lines of business offering workers compensation, commercial auto, and umbrella insurance). This segment currently represents roughly 40% of written premiums.
Investment Portfolio – An investment portfolio that is primarily invested in high-quality corporate, government, and/or municipal bonds of short duration.
Levers for Improvement
Returns going forward are likely to be driven by a combination of factors, all of which should lead to improved operating performance at some point over the next few years. As we see it, some combination of the following should drive Penn’s returns over the next couple of years:
The positive effects of a revamped capital structure, and increasing operating profitability – The capital associated with their recent conversion/capital raise has and should continue to benefit the company in a multitude of ways as it is deployed and leveraged into the company’s business over time. We believe that the capital raise has permanently improved the company’s business model, enhanced the strength and durability of its competitive position(s), as well as improve its long-term growth prospects. Why? Primarily because Penn is now liquid, well capitalized, and finally has the financial strength and flexibility to (1) capitalize on an improving pricing outlook and an improvement in the weakness of their over-leveraged competitors in their largest and best business segment, (2) opportunistically reinvest in its business when it’s the most strategically compelling to do so, and (3) buy back stock (due to the recent IPO).
The conversion/capital raise immediately provided the company’s insurance operations with some naturally embedded margin expansion and operating momentum (the effects of which should become even more pronounced as the cycle turns), which should provide the business with higher operating margins and the ability to grow its revenue/operating income at a faster clip going forward.
Penn now has the ability to meaningfully lower costs as the company no longer needs to purchase “stop loss” reinsurance (an expense that had been meaningfully distorting the businesses combined ratios in recent years). It also has new capacity to opportunistically write considerably more business at higher prices when the cycle turns (if we assume Penn operates at similar leverage levels as they have in the past, then the company could nearly double the amount of premiums they write without taking on a dime of debt).
With regard to Penn’s ability to add capacity, it’s also important to bring Penn Edge into the discussion. Penn Edge is Penn’s new middle market insurance product (more about Penn Edge here http://www.pennmillers.com/pmic/commbusiness/pennedge/), and we expect it will provide the company with better pricing and underwriting flexibility, not to mention a new growth platform that should serve as a solid base for the company to grow its top and bottom lines going forward through (1) leveraging its existing relationships more effectively and (2) as a platform to expand into new niche markets. Success on either front would provide the company with better scale and the ability to more effectively leverage their fixed expenses. Taking into account the fact that Penn has additional underwriting capacity and a high fixed expense ratio, and the fact that Penn’s staff is currently underutilized (according to management) and could therefore handle considerably more business at essentially no incremental cost, the results to the bottom line could be impressive and facilitate rapid improvements in the company’s operating margins as revenues grow over time. (pg. 21,22, investor presentation)
Keep in mind that Penn Edge is currently available only in their commercial segment (i.e., roughly 8 states) and that it will take some time to roll it out across Penn’s entire platform (management plans to bring it to all 33 states they currently do ag business in) and to gain some traction. It will likely be a few years before the full effects of the technology/transition really begin to show themselves in the company’s results. The company expects Penn Edge to be available in roughly 24 states by the end of 2010.
Favorable shifts in the underlying competitive dynamics of the agribusiness segment – Pricing wars (as mentioned above), and the inevitable industry shakeout that resulted, have provided Penn with an outstanding opportunity to take share from its undisciplined and over-leveraged competition, especially in attractive growth markets like the Midwest and the Northeast, where Penn currently possess small market share (and therefore ample room for growth). With competitors in these areas having particularly weak balance sheets (i.e., deteriorating financial strength), odds are decent that a ratings downgrade could result in the near future (an event that would allow Penn to almost certainly take a considerable amount of market share).
While many of their competitors are retrenching, Penn is improving their business model, strengthening their product offerings and market positions, and investing opportunistically to take advantage of attractive long-term growth opportunities (something we love to see).
An effective turnaround in the commercial business segment – Management’s decision to exit various unprofitable business lines and change their fundamental strategy in the commercial segment altogether is an intelligent one in our opinion. We think their efforts to more efficiently use their capital by redirecting their commercial business into select middle market niches (as opposed to their historical generalist approach in more commoditized business lines) should produce both higher margins and faster growth in this segment over time.
Buybacks – Given that thrift/mutual conversions are essentially the only investment opportunities where outsiders can invest alongside management both in advance, and on the same terms, of the initial public offering, and because of the discount to book that is typical of these types of opportunities post conversion, management’s willingness to both own and repurchase stock is particularly important. This is true, both because (1) buybacks are a good indication of managements conviction in the current level of the company’s undervaluation and (2) because of the rapid acceleration in per-share value that these buybacks can produce for shareholders. Notably, management invested roughly $1M each post-IPO and quickly rushed to authorize the repurchase another $2m shares almost immediately thereafter (and even better, has been following through on those buybacks since). For what it’s worth, famed value investor Michael Price invested roughly $1M immediately after the IPO as well (it’s never a bad thing to be in good company, especially when they have a long history of working with/guiding management teams in similar situations).
Obviously, as far as non-company specific issues go, any firming in the insurance market and/or rising interest rates would be a massive positive for the company and its underlying operating performance. At this point, some combination of rapidly rising earnings due to the ramp in both volumes and pricing on the premium front, and/or the resultant explosion in interest income that would result as interest rates rise (due to maturing assets being reinvested at more attractive yields), should drive results significantly higher going forward.
Management:
Management is relatively new (in particular the CEO, who was brought in to turn things around in 2005) but has plenty of industry experience and is more than capable of leading this business towards brighter days in the years ahead. They have been impressive on a variety of fronts since their arrival, but in particular regarding capital allocation. Examples include the timing of the recent conversion (genius), and the various buybacks the company has executed since. Incentive compensation is properly structured and aligned with shareholders, which is something else we feel is particularly important (especially when investing in a spread lending business). Further evidence in this regard can be seen in their decision to (1) re-engineer the commercial business by both shutting down unprofitable lines and terminating unprofitable relationships with “non-partner” brokers, and (2) their decision to refocus the segment on niche markets (mentioned above). Their decision to not bring Wall Street into the equation regarding the recent capital raise (saving fees, etc.) is yet another key indicator that management is focused on the right things. All in all, we like what we see. (pg.12, 13, investor presentation)
The fact that they have been buying back stock both through the company and, perhaps more importantly, personally, is a particularly meaningful signal in our opinion – it’s a sign that they’re focused on the right things (capital allocation wise) and that they believe that the company is undervalued/the strength of the company’s franchise is firmly intact.
Valuation and Risk
At its current price of $13.46 per share, the Company is trading at a roughly 35% discount to its tangible book value of $21.31 per share. Call us crazy, but we feel that a 35% discount to tangible book is simply too cheap on an absolute basis for a durable, overcapitalized niche insurer without material business risk and a high likelihood of generating a stable and growing stream of profits for years to come (if you’re wondering how it stacks up on a relative basis, it’s still too cheap, as the industry average price-to-tangible book multiple for P&C insurer’s is currently roughly 1x).
As far as earnings go, estimating them with any precision is clearly not easy given the cloudy nature of Penn’s outlook over the next few years. Yet, by examining the company’s historical ROE over the last few decades – which has generally varied between low single digit ROE’s and mid-teens ROE’s – we can get a good idea of the range of earnings to expect over a full market cycle, as well as a good estimate of what this business should likely earn in a “normal” year. With that in mind, if we assume the company can generate a ROE at the midpoint of its historical range of 10%, then Penn should be able to earn almost $2 in normal earnings and therefore is currently trading hands today at only 6-7x its normalized earnings power.
Although we are not exactly sure what the “correct” multiple should be on Penn’s normalized earnings given its present stage in its evolution, we are sure that it should be higher than the 6-7x it currently trades for. And notably, given all of the positive changes discussed throughout this analysis the 6-7x estimate above is likely conservative and we wouldn’t be surprised if it proves to be on the low end of what they eventually earn.
We believe that an investment in PMIC is low risk in nearly every way. Consider that it (1) currently trades hands at a drastic discount to tangible book and mid single digit estimate to normalized earnings power, (2) the company has no material credit risk and low financial leverage, (3) the multiple problems/issues that have plagued Penn’s results over the last few years have been either resolved and/or are no longer an issue, and (4) the company’s operating performance has stabilized and is poised to significantly improve over the coming months and years. With the above in mind, today’s valuation simply makes no sense and is just too cheap, all things considered.
We covered most of the traditional risks involved with Penn (underwriting, etc.) in the “rearview” sections above, but a few more are discussed below.
Liquidity – Granted, this is an illiquid microcap, so clearly a position in Penn needs to be sized accordingly. With that said, we think investors (at today’s price) are getting paid more than enough to assume the additional liquidity risk. Also, like so many cheap micro-caps, there is always the risk that they stay cheap and the investment in question remains “dead money” for far too long. This is a valid concern (to quote Klarman, “long duration mistakes are the mistakes that keep on taking.”), yet we don’t think this will be an issue in this case, both because of the sheer cheapness of Penn at today’s level and because of the multiple catalysts in place that should help bring about the realization of its underlying value. If today’s discount persists for long enough our guess is that management will simply just keep on buying back stock until the cycle turns and/or the market comes to its senses (bargains of this magnitude don’t last for long, they never do).
Competitive Industry – The insurance industry is obviously a very competitive industry and a real sustainable competitive advantage often proves fleeting. Nonetheless, this doesn’t worry us when all things are considered. Management clearly is focused on the right things, namely executing a differentiated approach in non-commoditized markets and cultivating a culture that focuses not on maximizing top line growth but on earning an economic profit on each and every policy written. Time will tell, but we believe this management team has the right combination of discipline, independence of spirit, expertise, and experience to build a sustainable franchise in an industry as highly competitive as insurance.
Ratings Downgrade – Obviously, a significant deterioration in Penn’s financial strength (as a result of higher than expected losses on policies) would affect both the volume and pricing of policies written after the fact, which could cause them to be essentially unable to write new business on profitable terms. Yet considering the conservative underwriting posture of this firm, and the fortress-like strength of their financial position, we feel this isn’t a material concern at the moment (although it may be for its competitors).
Catastrophe Risk – Considering that Penn’s primary focus within its agribusiness segment is on covering “middlemen’s” operations, and not producers or farmers, we don’t expect this will be a material issue. Again, what makes us comfortable with this aspect going forward, besides management’s history of intelligent underwriting (and emphasis on reinsurers with fortress like financial strength), is the fact that the company is both geographically diversified across their various business segments and, more importantly, they do not insure farm operations and/or crops on a standalone basis.
Asset Quality – With any insurance company there is always the risk that their reserves and/or book value could be meaningfully misstated or that they will suffer large losses in their investment portfolios (perhaps leading to a ratings downgrade or even bankruptcy). Considering what we know about the composition of Penn’s investment portfolio, as well as management’s history of being conservative in estimating losses and building reserves, this is not something we really worry about. In fact, if anything (at least if history is any guide) Penn’s history of consistently favorable developments regarding their loss reserves (i.e., they almost always overestimate the amount they need to put away for future losses) argues that the current book value is very likely not only correct but possibly understated.
Prolonged “Soft” Market – This issue doesn’t worry us, as the company’s focus on bottom line profitability, improving scale, etc., should allow it to generate a combined ratio south of 100 in case the market remains soft for the foreseeable future. With that said, we obviously think this is something to watch.
Now that we have briefly discussed why we feel that there is a low probability that one could permanently lose money, let’s take a few moments and consider the multitude of ways investors can win: (1) Penn’s earnings are likely to grow significantly from today’s level, as the company opportunistically deploys its excess cash at more attractive rates; (2) Penn’s tangible book value will grow in the process, as a portion of those earnings are retained over time; and (3) perhaps most important of all, management is not only financially capable, but more than willing to zealously buy back stock – which should further accelerate the growth in both Penn’s earnings and book value/per share, and hence shareholder value from today’s level.
To reiterate, in our experience it’s almost impossible for us to lose (and better yet, almost a near certainty we win) whenever we are able to purchase a durable, quality business with a stable and steadily growing intrinsic value at a roughly 35% discount to a rock solid tangible book value, especially if the company in question is run by a fully incentivized management team that “gets it” and is actively working to close the arbitrage (i.e., the discount to book) through stock buybacks, etc., as is the case here.
The Road Ahead – Penn’s results going forward are likely to be materially better than its past:
Interest Rates Can’t Stay at Zero Forever – With historically low interest rates and a portfolio that consists primarily of short duration quality securities, it doesn’t take a genius to understand that the present amount of interest income that the investment portfolio throws off is incredibly depressed. Yet the bright side of this reality is that it’s only a matter of time before interest rates begin to rise at some point over the next 3+ years (it’s not a matter of if, but when). As Penn’s short dated assets mature, they will be essentially immediately available for reinvestment at higher, more attractive yields – substantially boosting interest income in the process.
Today’s “Soft” Market Can’t last Forever – Although we can’t predict when the market will harden, we can predict that at some point it absolutely will. Because management refuses to write unprofitable insurance, the top line is destined to contract during periods like the present. Luckily, soft markets cannot last forever and when the insurance market begins to firm at some point over the next few years, we expect both pricing and volumes to ramp considerably – Substantially boosting the absolute level of Penn’s revenues and profits.
Recent restructuring initiatives and investments in operational efficiencies (i.e., Penn Edge) Should Begin to Pay Off – Penn’s decision to shutter underperforming divisions and recent investments in an IT overhaul should further improve their profitability/operational efficiency over the next few years. Penn Edge, for example, should significantly improve their ability to quote and underwrite more policies in existing and new markets – and should serve as an excellent growth platform to more effectively penetrate larger and more attractive markets (i.e., it offers a good opportunity for the company to apply its money making ways to new markets, and hence the creation of additional earnings power for the firm going forward). These initiatives/investments should result in meaningfully improved profitability/operating performance for the firm as a whole over time.
Taken together, all of the above aspects highlight this company’s rather attractive underlying fundamental dynamic, all of which should boost Penn’s results by bolstering both sales and margins. Again, with both of their insurance operations stabilized, freshly raised capital, and interest rates at roughly zero, we feel that we can finally say with confidence that an operational inflection point has been reached and that it’s only a matter of time before today’s headwinds become tomorrow’s tailwinds. Given the new found operating leverage inherent in their post conversion business model we expect that when the cycle turns at some point over the next few years, Penn’s earnings will accelerate like never before as the company begins to approach its normalized earnings capacity.
Catalysts:
Sheer Value – Today’s price is just too cheap to last long.
Improving Operating Performance
Continued Value Accretive Share Repurchases – additional buybacks at anywhere close to today’s deeply discounted price will rapidly accelerate the growth in per share value.
Potential Buyout – Considering the quality of Penn’s assets and its attractive policy base in niche markets with attractive long-term fundamentals, an acquirer – with the ability to wring out excess costs and/or looking to achieve some policy diversification could pay a significant premium – say 1.3x book – and even then the acquirer would likely still be getting a fantastic bargain.
Conclusion:
The trick as investors is to uncover situations with limited risk that are very likely to reward investors with a high return regardless of the level of the general market environment. That, in our opinion, is the beauty of an investment in Penn Miller – as even if we assume that we experience tremendously challenging economic headwinds going forward, our feeling is that investors will likely still do well.
After all, it’s pretty hard to lose money purchasing a good (not great), relatively recession resistant business that is a dominant player in a niche industry (with attractive long-term fundamentals and decent growth prospects) for a roughly 35% discount to a solid and growing TBV and a mid-single digit multiple to normalized earnings. Even more so when there are a variety of internal and external catalysts that should bring about the realization of value in relatively short order and when the company is question is run by a quality management team that is rapidly buying back stock and positioning the company for long-term success. In our experience, this has been (and should continue to be) a recipe for success.
Miscellaneous:
Investor Presentation
http://www.sec.gov/Archives/edgar/data/1453820/000095012309071916/w76669exv99w1.htm
2009 Earnings Release
http://www.sec.gov/Archives/edgar/data/1453820/000114420410015969/v178695_ex99-1.htm
Annual Report
http://www.sec.gov/Archives/edgar/data/1453820/000114420410017336/v178527_10k.htm
Above Average Odds
http://aboveaverageodds.wordpress.com/
Seth Klarman
“If you spend your energies looking for and analyzing situations not closely followed by other informed investors, your chance of finding bargains greatly increases – the trick is locating those opportunities.”
Joel Greenblatt
Thesis:
An investment in the Penn Miller Holding Company (PMIC, Financial), at or around the current price, offers bargain-hunting investors the chance to purchase a classic low-risk, high-return special situation that possesses nearly all of the qualities we look for in a great investment. Of particular note about PMIC is: (1) a low valuation (both absolute and relative to peers), (2) a good, fully-incentivized management team, (3) near- to medium-term operating momentum, (4) a promising long-term business model, and (5) a variety of internal and external catalysts that should help bring about the convergence between price and value.
Given the company’s recent conversion from a mutual to a publicly-traded holding company (and the unique underlying dynamic/implications of such a transition), and the fact that it’s in a cyclical business that is operating at a cyclical trough, we think it is reasonable to believe that Penn’s underlying operating performance is poised to significantly improve going forward. The bottom line here is that as the insurance market normalizes and the company’s newfound operating leverage begins to kick in, the market will come to its senses and award this undiscovered quality company with a more appropriate multiple on much higher profits at some point in the coming months and years – driving returns of potentially 100%+ over the next 2-3 years with limited downside risk.
Brief Business Description:
The Penn Miller Holding Company is a regional property and casualty insurance company that originally opened its doors in 1887 in Huntington, Pennsylvania. Its primary business is its agribusiness segment (60% of premiums), which tends to cover middlemen operations and not product producers or farms (i.e., the company generally does not insure farms or farming operations). Its commercial segment (40% of premiums) typically writes business owners packages for small businesses.
Penn Millers currently has license to operate in 39 states; and sells its agricultural insurance products in 33 states and commercial insurance products in 8 states. The company is headquartered in Wilkes-Barre, Pennsylvania.
Mutual Conversions – A Secret Hiding Place of Stock Market Profits:
In order to understand why mutual conversions offer such an attractive area for uncovering inefficiently priced opportunities (and hence tend to be a secret hiding place of stock market profits), it is useful to quickly walk through the mechanics of a mutual conversion in order to more fully understand why this is so.
When a mutual insurance company converts, it goes from being owned by its policyholders to being owned by a holding company which, in turn, is owned by the general public. The conversion process usually starts with a subscription offering, through which the policyholders, employees, officers, and directors of the institution in question are given the right to buy shares, typically for $10 each, in the new holding company. If there are any shares remaining after the subscription offering (and often there are not) the remaining shares are usually then offered first to people in the local communities that the insurance company serves, and then to the general public.
The key aspect for investors to understand here is that not only do shareholders of the newly public company have a full claim on the IPO proceeds (as is typical), they also receive a claim on all the pre-conversion market value at no cost. Unlike any other type of initial public offering, in a mutual/thrift conversion there are no prior shareholders; all of the shares in the institution that will be outstanding after the offering are issued and sold on the conversion, so the entire existing value, as well as the cash raised in the recent IPO, will belong to the post- conversion shareholders. If you’re unfamiliar with mutual/thrift conversion, you may want to go ahead and re-read this paragraph one more time
.Again, the conversion proceeds are added to the pre-existing capital of the institution, which is indirectly handed to the new shareholders without cost to them. When describing the favorable arithmetic of thrift conversions and the reasons why investing in thrift conversions can offer such compelling investment opportunities for bargain hunting investors, Seth Klarman stated that “In a real sense, investors in a thrift conversion are buying their own money and getting the preexisting capital in the thrift for free.” Peter Lynch put it a little differently, once remarking that from the perspective of the IPO investor, this was equivalent to buying a house, moving in, and finding the seller had left the sale proceeds in the house for the buyer to keep. Indeed!
In Penn’s case, investors who participated in the offering on October 16, 2009, (and/or purchased the company post IPO) essentially paid roughly $50m for 1) $50M ($46.2M net) in newly raised cash, and 2) Penn’s $56.5m in existing equity. In other words, investors got their investment back immediately with Penn’s existing shareholder’s equity and insurance operations thrown in for free. Pretty good deal, no?
Why is it Mispriced?
Penn is an obscure, under-appreciated micro-cap that (1) just recently became public and hence is not covered by Wall Street, (2) has been facing both company specific and industry wide problems over the last few years, and (3) has a recent history of mediocre operating performance. Taken together, these issues/concerns have not only temporarily depressed results, but more importantly are masking what we believe is an impressive transformation in the company’s core business and future business prospects (offering yet another classic example of the market mis-pricing a business due to its inability to see past short-term cyclical and operational challenges due to its myopic fixation on the rear view).
Additionally, any time the future doesn’t give a particularly good view of what the prospective performance of a business is likely to be, there is an outsized chance the market will mis-price the opportunity in question. Typically, such situations are created when a business is in the midst of a major change in corporate organization and/or capital structure, and where the implications of the changes are not well understood. The conversion of Penn from a mutual to a publicly traded company late last year provides a perfect example of this phenomenon, as the implications of the conversion (and the underlying financial dynamics associated with it) are still unknown and/or remain misunderstood by most market participants.
To reiterate, Penn’s current mis-pricing is due to a recent history of relatively lackluster results and a combined ratio that appears superficially worse than it is. Thankfully, both of these trends are in the process of reversing. Additionally, the company has experienced a confluence of negative external events that, taken together, provided a near perfect storm of operational headwinds, such as (1) a cyclical recession in the insurance industry, (2) compressed short-term interest rates, and (3) a variety of operational efficiency and restructuring initiatives that are just now beginning to bear fruit.
The Rearview:
(Note – The following conclusions are substantiated by the Penn Miller corporate overview presentation, 10k’s, etc., which are attached.)
Considering the 35% discount to book, risk-averse investors need to get comfortable with the fact that PMIC’s operations have positive value and that the current price is not depressed for some unforeseen/undisclosed fundamental business reason. In order to do that, they must ask (and satisfactorily answer) three basic questions:
(1)How good has management been at pricing policies historically?
(2)How adequate has its loss estimates and loss reserves been?
(3)How well has it invested its float (have they invested intelligently)?
In regards to the first question, a look at the company’s combined ratios doesn’t inspire much confidence, at least at first glance, as it has been consistently north of 100 for the last few years. A deeper analysis, however, reveals that things aren’t quite as bad as they seem as (A) most of the losses of the last few years were due to the poor performance of a couple of lines within its commercial segment, all of which have since been discontinued, and (B) the company will be able to significantly reduce the amount of reinsurance they purchase going forward, which has been a considerable drag on results in recent years (and artificially inflated Penn’s combined ratio in the process). (pg.26, investor presentation)
Importantly, if you back out the cost of the “stop loss” reinsurance contract and the results from the unprofitable (and now discontinued) commercial lines, and further assume that they can continue to profitably underwrite their remaining lines in both segments (all reasonable assumptions in our opinion), then a properly adjusted analysis of the rear view implies that Penn would be consistently profitable on a going forward basis. There is obviously considerable room for improvement here, and the fact that Penn could have been marginally profitable is nothing to get excited about in and of itself. Regardless, we think the company’s underwriting performance should be considerably better in the future than a historical examination outlined above would suggest (more on this later). (pg. 29, investor presentation)
In regards to the second question addressing management’s history of being conservative in its reserving policies and loss estimates, our analysis would indicate that they have had strong success in this regard. This further bolsters our conviction in management and the value of the company’s operations, and more importantly minimizes our fear of experiencing the type of nasty surprises (read blowups) that are so common with undisciplined insurers. Our multi-year analysis shows that PMIC has enjoyed over $8 million in net favorable reserve developments over the last four years alone (10K pg F-34). So again, the historical performance of their policies suggests that management has done a more than adequate job of estimating its loss estimates and loan reserves accurately.
Looking at the third question (whether or not management has a history of intelligently managing their float), our analysis yielded positive results yet again. Taking a look at how the portfolio performed beginning in 2008 through today is helpful in thinking about this issue (as it provides a great stress test, so to speak). With that said, we feel that the fact that most of the losses they experienced in their portfolio have since reversed themselves, and that the company didn’t own any toxic waste (i.e., RMBS, CMBS, etc.), is a testament to their conservative nature. If we fast forward to today, we see more of the same, as Penn’s investment portfolio is primarily comprised of high-quality corporate, government, and municipal bonds with relatively short durations. Over 96% of Penn’s investment portfolio is rated ‘A’ or better by Standard & Poor’s, and the average effective duration of the portfolio is 3.4 years (see pg 19 of 10K). We like this, and believe it provides the company with the flexibility to both take advantage of changing market conditions and eventually, a rise in interest rates.
Again, for a variety of reasons we feel that the company’s present positioning is both prudent and wise. After all, why stretch for yield or extend duration in today’s uncertain, low interest rate environment? Management’s emphasis on shorter duration, higher quality securities reveals a team that is artfully balancing downside protection with upside optionality, something we like very much. Keep in mind that, by owning a high quality portfolio of securities, Penn’s management has gone a long way toward ensuring that their balance sheet will remain fortress-like and intact under nearly any scenario short of Armageddon. Also, by simultaneously insisting on short-duration assets with nearer term maturities, they ensure that they will remain flexible enough to immediately react, as well as capitalize on, a rising rate environment (for the most part). Again, we believe rising interest rates at some point over the next 3+ years is a near certainty – It’s not a question of if they rise, just when, how fast and how far! The bottom line here is that, looking out a few years, PMIC’s investment portfolio is not only conservative, but perfectly positioned to do well in pretty much any environment.
Operations and Levers for Improvement:
Operations
Penn Miller has 3 separate “earnings engines,” so to speak:
Agribusiness Segment – A specialized insurance company with a strong competitive position in one of the more attractive niche markets in the insurance industry today (primarily due to its attractive long-term fundamentals, limited competition, improving pricing outlook and substantial opportunity for profitable growth going forward). Better yet, Penn in is perfectly positioned to capitalize on various expansion opportunities, making an already strong competitive position meaningfully stronger in the near- to medium-term. (pg. 15, investor presentation)
The agribusiness segment usually covers manufacturers, processors, and distributors of products in the agricultural industry, and focuses primarily on fire and allied lines, inland marine, general liability, commercial automobile workers compensation, and umbrella liability insurance. For example, the company typically markets to businesses such as grain and storage elevators, flour mills, livestock feed manufacturers, fertilizer blending and application, cotton gins, livestock feed lots, mushroom growers, farm supply stores, produce packing, and seed merchants. This segment currently represents roughly 60% of written premiums.
Some historical context helps in understanding why we are excited about Penn’s future prospects in Agribusiness. First, Zurich attempted to try and dominate the industry earlier this decade, which ended up giving way to an industry wide pricing war. As always, huge losses resulted and Zurich ended up exiting the industry (as did other weaker players). As the third largest player, we think there is a good chance Penn benefits materially from this shakeout, and the improving pricing outlook that is the result of it, going forward.
Commercial Business Segment – A commercial business insurance company that is currently in the midst of an operational restructuring/turnaround, and is in the process of transitioning from a generalist insurer of small business to a specialist focused on select industries for both small and middle market customers. Going forward, this segment will share a niche strategy that is identical to the Ag segment, namely to identify discrete underwriting risks where competition is limited and they can add value through personal service. It is too early to draw any definite conclusions here about how successful this turnaround will be, but we think it’s a smart move and that the chances of success are good. (pg. 18, investor presentation)
The segment typically provides insurance coverage primarily to middle-market commercial businesses. They target select low- to medium-hazard businesses such as retailers (including beverage stores, floor covering stores, florists, grocery stores, office equipment and supplies stores, dry cleaners, printers, and shopping centers), hospitality (such as restaurants and hotels), artisan contractor businesses (such as electrical, plumbing, and landscaping), professional services (such as accountants, insurance agencies, medical offices, and optometrists), office buildings, and select light manufacturing and wholesale businesses. The commercial segment’s primary product is their “solutions” business owner’s policy, which covers major property and liability exposures, crime, and business interruption, utilizing a simplified ratings program (other lines of business offering workers compensation, commercial auto, and umbrella insurance). This segment currently represents roughly 40% of written premiums.
Investment Portfolio – An investment portfolio that is primarily invested in high-quality corporate, government, and/or municipal bonds of short duration.
Levers for Improvement
Returns going forward are likely to be driven by a combination of factors, all of which should lead to improved operating performance at some point over the next few years. As we see it, some combination of the following should drive Penn’s returns over the next couple of years:
The positive effects of a revamped capital structure, and increasing operating profitability – The capital associated with their recent conversion/capital raise has and should continue to benefit the company in a multitude of ways as it is deployed and leveraged into the company’s business over time. We believe that the capital raise has permanently improved the company’s business model, enhanced the strength and durability of its competitive position(s), as well as improve its long-term growth prospects. Why? Primarily because Penn is now liquid, well capitalized, and finally has the financial strength and flexibility to (1) capitalize on an improving pricing outlook and an improvement in the weakness of their over-leveraged competitors in their largest and best business segment, (2) opportunistically reinvest in its business when it’s the most strategically compelling to do so, and (3) buy back stock (due to the recent IPO).
The conversion/capital raise immediately provided the company’s insurance operations with some naturally embedded margin expansion and operating momentum (the effects of which should become even more pronounced as the cycle turns), which should provide the business with higher operating margins and the ability to grow its revenue/operating income at a faster clip going forward.
Penn now has the ability to meaningfully lower costs as the company no longer needs to purchase “stop loss” reinsurance (an expense that had been meaningfully distorting the businesses combined ratios in recent years). It also has new capacity to opportunistically write considerably more business at higher prices when the cycle turns (if we assume Penn operates at similar leverage levels as they have in the past, then the company could nearly double the amount of premiums they write without taking on a dime of debt).
With regard to Penn’s ability to add capacity, it’s also important to bring Penn Edge into the discussion. Penn Edge is Penn’s new middle market insurance product (more about Penn Edge here http://www.pennmillers.com/pmic/commbusiness/pennedge/), and we expect it will provide the company with better pricing and underwriting flexibility, not to mention a new growth platform that should serve as a solid base for the company to grow its top and bottom lines going forward through (1) leveraging its existing relationships more effectively and (2) as a platform to expand into new niche markets. Success on either front would provide the company with better scale and the ability to more effectively leverage their fixed expenses. Taking into account the fact that Penn has additional underwriting capacity and a high fixed expense ratio, and the fact that Penn’s staff is currently underutilized (according to management) and could therefore handle considerably more business at essentially no incremental cost, the results to the bottom line could be impressive and facilitate rapid improvements in the company’s operating margins as revenues grow over time. (pg. 21,22, investor presentation)
Keep in mind that Penn Edge is currently available only in their commercial segment (i.e., roughly 8 states) and that it will take some time to roll it out across Penn’s entire platform (management plans to bring it to all 33 states they currently do ag business in) and to gain some traction. It will likely be a few years before the full effects of the technology/transition really begin to show themselves in the company’s results. The company expects Penn Edge to be available in roughly 24 states by the end of 2010.
Favorable shifts in the underlying competitive dynamics of the agribusiness segment – Pricing wars (as mentioned above), and the inevitable industry shakeout that resulted, have provided Penn with an outstanding opportunity to take share from its undisciplined and over-leveraged competition, especially in attractive growth markets like the Midwest and the Northeast, where Penn currently possess small market share (and therefore ample room for growth). With competitors in these areas having particularly weak balance sheets (i.e., deteriorating financial strength), odds are decent that a ratings downgrade could result in the near future (an event that would allow Penn to almost certainly take a considerable amount of market share).
While many of their competitors are retrenching, Penn is improving their business model, strengthening their product offerings and market positions, and investing opportunistically to take advantage of attractive long-term growth opportunities (something we love to see).
An effective turnaround in the commercial business segment – Management’s decision to exit various unprofitable business lines and change their fundamental strategy in the commercial segment altogether is an intelligent one in our opinion. We think their efforts to more efficiently use their capital by redirecting their commercial business into select middle market niches (as opposed to their historical generalist approach in more commoditized business lines) should produce both higher margins and faster growth in this segment over time.
Buybacks – Given that thrift/mutual conversions are essentially the only investment opportunities where outsiders can invest alongside management both in advance, and on the same terms, of the initial public offering, and because of the discount to book that is typical of these types of opportunities post conversion, management’s willingness to both own and repurchase stock is particularly important. This is true, both because (1) buybacks are a good indication of managements conviction in the current level of the company’s undervaluation and (2) because of the rapid acceleration in per-share value that these buybacks can produce for shareholders. Notably, management invested roughly $1M each post-IPO and quickly rushed to authorize the repurchase another $2m shares almost immediately thereafter (and even better, has been following through on those buybacks since). For what it’s worth, famed value investor Michael Price invested roughly $1M immediately after the IPO as well (it’s never a bad thing to be in good company, especially when they have a long history of working with/guiding management teams in similar situations).
Obviously, as far as non-company specific issues go, any firming in the insurance market and/or rising interest rates would be a massive positive for the company and its underlying operating performance. At this point, some combination of rapidly rising earnings due to the ramp in both volumes and pricing on the premium front, and/or the resultant explosion in interest income that would result as interest rates rise (due to maturing assets being reinvested at more attractive yields), should drive results significantly higher going forward.
Management:
Management is relatively new (in particular the CEO, who was brought in to turn things around in 2005) but has plenty of industry experience and is more than capable of leading this business towards brighter days in the years ahead. They have been impressive on a variety of fronts since their arrival, but in particular regarding capital allocation. Examples include the timing of the recent conversion (genius), and the various buybacks the company has executed since. Incentive compensation is properly structured and aligned with shareholders, which is something else we feel is particularly important (especially when investing in a spread lending business). Further evidence in this regard can be seen in their decision to (1) re-engineer the commercial business by both shutting down unprofitable lines and terminating unprofitable relationships with “non-partner” brokers, and (2) their decision to refocus the segment on niche markets (mentioned above). Their decision to not bring Wall Street into the equation regarding the recent capital raise (saving fees, etc.) is yet another key indicator that management is focused on the right things. All in all, we like what we see. (pg.12, 13, investor presentation)
The fact that they have been buying back stock both through the company and, perhaps more importantly, personally, is a particularly meaningful signal in our opinion – it’s a sign that they’re focused on the right things (capital allocation wise) and that they believe that the company is undervalued/the strength of the company’s franchise is firmly intact.
Valuation and Risk
At its current price of $13.46 per share, the Company is trading at a roughly 35% discount to its tangible book value of $21.31 per share. Call us crazy, but we feel that a 35% discount to tangible book is simply too cheap on an absolute basis for a durable, overcapitalized niche insurer without material business risk and a high likelihood of generating a stable and growing stream of profits for years to come (if you’re wondering how it stacks up on a relative basis, it’s still too cheap, as the industry average price-to-tangible book multiple for P&C insurer’s is currently roughly 1x).
As far as earnings go, estimating them with any precision is clearly not easy given the cloudy nature of Penn’s outlook over the next few years. Yet, by examining the company’s historical ROE over the last few decades – which has generally varied between low single digit ROE’s and mid-teens ROE’s – we can get a good idea of the range of earnings to expect over a full market cycle, as well as a good estimate of what this business should likely earn in a “normal” year. With that in mind, if we assume the company can generate a ROE at the midpoint of its historical range of 10%, then Penn should be able to earn almost $2 in normal earnings and therefore is currently trading hands today at only 6-7x its normalized earnings power.
Although we are not exactly sure what the “correct” multiple should be on Penn’s normalized earnings given its present stage in its evolution, we are sure that it should be higher than the 6-7x it currently trades for. And notably, given all of the positive changes discussed throughout this analysis the 6-7x estimate above is likely conservative and we wouldn’t be surprised if it proves to be on the low end of what they eventually earn.
We believe that an investment in PMIC is low risk in nearly every way. Consider that it (1) currently trades hands at a drastic discount to tangible book and mid single digit estimate to normalized earnings power, (2) the company has no material credit risk and low financial leverage, (3) the multiple problems/issues that have plagued Penn’s results over the last few years have been either resolved and/or are no longer an issue, and (4) the company’s operating performance has stabilized and is poised to significantly improve over the coming months and years. With the above in mind, today’s valuation simply makes no sense and is just too cheap, all things considered.
We covered most of the traditional risks involved with Penn (underwriting, etc.) in the “rearview” sections above, but a few more are discussed below.
Liquidity – Granted, this is an illiquid microcap, so clearly a position in Penn needs to be sized accordingly. With that said, we think investors (at today’s price) are getting paid more than enough to assume the additional liquidity risk. Also, like so many cheap micro-caps, there is always the risk that they stay cheap and the investment in question remains “dead money” for far too long. This is a valid concern (to quote Klarman, “long duration mistakes are the mistakes that keep on taking.”), yet we don’t think this will be an issue in this case, both because of the sheer cheapness of Penn at today’s level and because of the multiple catalysts in place that should help bring about the realization of its underlying value. If today’s discount persists for long enough our guess is that management will simply just keep on buying back stock until the cycle turns and/or the market comes to its senses (bargains of this magnitude don’t last for long, they never do).
Competitive Industry – The insurance industry is obviously a very competitive industry and a real sustainable competitive advantage often proves fleeting. Nonetheless, this doesn’t worry us when all things are considered. Management clearly is focused on the right things, namely executing a differentiated approach in non-commoditized markets and cultivating a culture that focuses not on maximizing top line growth but on earning an economic profit on each and every policy written. Time will tell, but we believe this management team has the right combination of discipline, independence of spirit, expertise, and experience to build a sustainable franchise in an industry as highly competitive as insurance.
Ratings Downgrade – Obviously, a significant deterioration in Penn’s financial strength (as a result of higher than expected losses on policies) would affect both the volume and pricing of policies written after the fact, which could cause them to be essentially unable to write new business on profitable terms. Yet considering the conservative underwriting posture of this firm, and the fortress-like strength of their financial position, we feel this isn’t a material concern at the moment (although it may be for its competitors).
Catastrophe Risk – Considering that Penn’s primary focus within its agribusiness segment is on covering “middlemen’s” operations, and not producers or farmers, we don’t expect this will be a material issue. Again, what makes us comfortable with this aspect going forward, besides management’s history of intelligent underwriting (and emphasis on reinsurers with fortress like financial strength), is the fact that the company is both geographically diversified across their various business segments and, more importantly, they do not insure farm operations and/or crops on a standalone basis.
Asset Quality – With any insurance company there is always the risk that their reserves and/or book value could be meaningfully misstated or that they will suffer large losses in their investment portfolios (perhaps leading to a ratings downgrade or even bankruptcy). Considering what we know about the composition of Penn’s investment portfolio, as well as management’s history of being conservative in estimating losses and building reserves, this is not something we really worry about. In fact, if anything (at least if history is any guide) Penn’s history of consistently favorable developments regarding their loss reserves (i.e., they almost always overestimate the amount they need to put away for future losses) argues that the current book value is very likely not only correct but possibly understated.
Prolonged “Soft” Market – This issue doesn’t worry us, as the company’s focus on bottom line profitability, improving scale, etc., should allow it to generate a combined ratio south of 100 in case the market remains soft for the foreseeable future. With that said, we obviously think this is something to watch.
Now that we have briefly discussed why we feel that there is a low probability that one could permanently lose money, let’s take a few moments and consider the multitude of ways investors can win: (1) Penn’s earnings are likely to grow significantly from today’s level, as the company opportunistically deploys its excess cash at more attractive rates; (2) Penn’s tangible book value will grow in the process, as a portion of those earnings are retained over time; and (3) perhaps most important of all, management is not only financially capable, but more than willing to zealously buy back stock – which should further accelerate the growth in both Penn’s earnings and book value/per share, and hence shareholder value from today’s level.
To reiterate, in our experience it’s almost impossible for us to lose (and better yet, almost a near certainty we win) whenever we are able to purchase a durable, quality business with a stable and steadily growing intrinsic value at a roughly 35% discount to a rock solid tangible book value, especially if the company in question is run by a fully incentivized management team that “gets it” and is actively working to close the arbitrage (i.e., the discount to book) through stock buybacks, etc., as is the case here.
The Road Ahead – Penn’s results going forward are likely to be materially better than its past:
Interest Rates Can’t Stay at Zero Forever – With historically low interest rates and a portfolio that consists primarily of short duration quality securities, it doesn’t take a genius to understand that the present amount of interest income that the investment portfolio throws off is incredibly depressed. Yet the bright side of this reality is that it’s only a matter of time before interest rates begin to rise at some point over the next 3+ years (it’s not a matter of if, but when). As Penn’s short dated assets mature, they will be essentially immediately available for reinvestment at higher, more attractive yields – substantially boosting interest income in the process.
Today’s “Soft” Market Can’t last Forever – Although we can’t predict when the market will harden, we can predict that at some point it absolutely will. Because management refuses to write unprofitable insurance, the top line is destined to contract during periods like the present. Luckily, soft markets cannot last forever and when the insurance market begins to firm at some point over the next few years, we expect both pricing and volumes to ramp considerably – Substantially boosting the absolute level of Penn’s revenues and profits.
Recent restructuring initiatives and investments in operational efficiencies (i.e., Penn Edge) Should Begin to Pay Off – Penn’s decision to shutter underperforming divisions and recent investments in an IT overhaul should further improve their profitability/operational efficiency over the next few years. Penn Edge, for example, should significantly improve their ability to quote and underwrite more policies in existing and new markets – and should serve as an excellent growth platform to more effectively penetrate larger and more attractive markets (i.e., it offers a good opportunity for the company to apply its money making ways to new markets, and hence the creation of additional earnings power for the firm going forward). These initiatives/investments should result in meaningfully improved profitability/operating performance for the firm as a whole over time.
Taken together, all of the above aspects highlight this company’s rather attractive underlying fundamental dynamic, all of which should boost Penn’s results by bolstering both sales and margins. Again, with both of their insurance operations stabilized, freshly raised capital, and interest rates at roughly zero, we feel that we can finally say with confidence that an operational inflection point has been reached and that it’s only a matter of time before today’s headwinds become tomorrow’s tailwinds. Given the new found operating leverage inherent in their post conversion business model we expect that when the cycle turns at some point over the next few years, Penn’s earnings will accelerate like never before as the company begins to approach its normalized earnings capacity.
Catalysts:
Sheer Value – Today’s price is just too cheap to last long.
Improving Operating Performance
Continued Value Accretive Share Repurchases – additional buybacks at anywhere close to today’s deeply discounted price will rapidly accelerate the growth in per share value.
Potential Buyout – Considering the quality of Penn’s assets and its attractive policy base in niche markets with attractive long-term fundamentals, an acquirer – with the ability to wring out excess costs and/or looking to achieve some policy diversification could pay a significant premium – say 1.3x book – and even then the acquirer would likely still be getting a fantastic bargain.
Conclusion:
The trick as investors is to uncover situations with limited risk that are very likely to reward investors with a high return regardless of the level of the general market environment. That, in our opinion, is the beauty of an investment in Penn Miller – as even if we assume that we experience tremendously challenging economic headwinds going forward, our feeling is that investors will likely still do well.
After all, it’s pretty hard to lose money purchasing a good (not great), relatively recession resistant business that is a dominant player in a niche industry (with attractive long-term fundamentals and decent growth prospects) for a roughly 35% discount to a solid and growing TBV and a mid-single digit multiple to normalized earnings. Even more so when there are a variety of internal and external catalysts that should bring about the realization of value in relatively short order and when the company is question is run by a quality management team that is rapidly buying back stock and positioning the company for long-term success. In our experience, this has been (and should continue to be) a recipe for success.
Miscellaneous:
Investor Presentation
http://www.sec.gov/Archives/edgar/data/1453820/000095012309071916/w76669exv99w1.htm
2009 Earnings Release
http://www.sec.gov/Archives/edgar/data/1453820/000114420410015969/v178695_ex99-1.htm
Annual Report
http://www.sec.gov/Archives/edgar/data/1453820/000114420410017336/v178527_10k.htm
Above Average Odds
http://aboveaverageodds.wordpress.com/
