American Physicians Service Gr AMPH
February 21, 2007 - 10:38pm EST by
abrams705
2007 2008
Price: 17.50 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 49 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Back out the $8/share in net cash and American Physicians Service Group stock is cheap at a trailing P/E of 10x.  Better yet, it’s set to merge with a related company in a highly EPS accretive transaction, which makes the P/E drop to 5x.

 

For further background, you can check out a timely previous post from another member two years ago.  I’ll first discuss AMPH as it looks today, and then talk about the implications of the pending merger.

 

 

THE COMPANY TODAY

 

AMPH is an extraordinarily profitable $49 million market cap company based in Austin, Texas.  It has two businesses, APS Insurance and APS Financial, both with high ROEs and great cash flow: if you back out the cash and securities from shareholders equity, AMPH has been earning over 100% ROEs for the past few years.  Historically, the two segments have each accounted for roughly half of AMPH’s earnings, but with the hard market in insurance the last couple of years, profits have been tilted heavily towards insurance.

 

APS Insurance is the manager of Texas’s 3rd largest medical malpractice insurer, American Physicians Insurance Exchange, or APIE.  Note that APS is not an actual insurance company itself, it’s just the hired manager.  In legally specific terms, APIE is a reciprocal insurance exchange and APS is its attorney-in-fact, hired by APIE’s Board of Directors to manage the firm.  The crucial point for now is that APS Insurance takes on no direct underwriting risk; it simply receives a management fee off the top and also receives a profit-sharing fee.  This arrangement will disappear with the pending merger, so I won’t dwell on the details, but suffice it to say that this is an astonishingly profitable arrangement for APS Insurance, since not only does it have no risk to its capital, it has virtually no invested capital at all!  In 2005, APS Insurance reported $15.5 million in revenues and $5.3 mil in segment operating income.  The profit margins are even better than they look, since the revenues include over $4 million in pass-through commissions.

 

APS Financial is a small, fixed-income focused securities brokerage firm.  AMPH entered this business in the early 1980s, hoping to cross-sell investment services to its doctor client base, but that strategy never panned out, and APS Financial eventually shifted its attention to institutional clients, which remain its bread and butter today.  It’s been quite profitable, with ROEs I’ve been told in the 20-25% range historically (the company doesn’t provide enough information for an outsider to confirm this).  However, the vast majority of its revenues are from bond trading commissions, which have been somewhat weak the past year or so.  With the environment only getting tougher, they’ve begun diversifying into asset management and investment banking, though both are still quite small.  In 2005, APS Financial reported $18.5 million in revenues and $2.3 million in segment operating income.

 

The quick financial summary using September 30, 2006, figures is this.  AMPH has $23.6 million of cash and securities ($8.15/share on 2.9 million shares outstanding) and no debt.  It earned $0.96/share in the trailing 12 months excluding investment gains and interest income.  So backing out the cash from the today’s $17.50 stock price, you get a trailing P/E of 9.7x.  This is cheap, but the proposed merger discussed next makes the multiple look even cheaper.

 

 

THE PROPOSED MERGER

 

AMPH is proposing to acquire APIE, the medmal insurer that it manages, for about $39 million, mostly in AMPH stock.  The purchase price is 0.9x surplus.

 

The deal’s strategic rationale makes sense.  AMPH has excess capital, while APIE is capital-constrained.  AMPH’s CEO Ken Shifrin is a smart and aggressive entrepreneur, and is reluctant to re-invest the excess cash in businesses he doesn’t know as well.  APIE, meanwhile, because of its unusual reciprocal exchange structure, can’t raise capital easily.  This combination solves both problems in one stroke.  There is absolutely no integration risk.  Not a single thing will change operationally after the deal closes – the same people will run it in the same way it’s been run before.  All the deal does is collapse the reciprocal/attorney-in-fact dual firm structure.

 

The highlight of the deal, though, is that the profit accretion is enormous, both near-term and longer term.  AMPH will report somewhere around $1/share in earnings for the full year 2006.  Pro forma of the APIE merger, that will be more like $3.30/share of earnings!  Below are earnings before and pro forma the merger, excluding one-time gains.

 

                                                2005                2006e              2007e

            Net Income                   $3.5 mil            $2.7 mil            $2.4 mil

            Shares Outst.                  2.9 mil              2.9 mil              2.9 mil

            EPS                              $1.20               $0.91               $0.82
 
            Net Income, pf             $12.3 mil          $16.5 mil          $10.0 mil
            Shares Outst. pf                5.0 mil              5.0 mil              5.0 mil
            EPS, pf                         $2.45               $3.30               $2.00

 

The big pro forma accretion reflects the benefit of owning all of APIE’s profits, rather than just receiving a portion of it as a profit-sharing fee.  Under the current agreement, AMPH receives 50% of APIE’s net income, but it’s capped as a percentage of APIE’s gross earned premiums.  So in highly profitable years like 2005, 2006, and most likely 2007, AMPH caps out on the profit-sharing fee and misses out on the upside.  The total annual revenue AMPH has received from APIE has been flat at $11 million since 2004, even though APIE’s net income has tripled in that span, because APIE’s earned premium revenue has been flat.  In effect, AMPH has left multiple dollars of EPS on the table.  This deal should double AMPH’s normalized nearing power over a full cycle from $0.80-1.00/share to $1.50-2.00/share.

 

There is one noteworthy negative to the deal for AMPH shareholders: AMPH will own an actual insurance company, so it’ll be exposed to all the capital needs and claims liabilities like any other insurer, nullifying its superb financial profile as an attorney-in-fact.  So all else equal, one should pay a lot lower multiple for a dollar of earnings from the new AMPH than for a dollar of earnings from the old AMPH.  However, this significant negative is offset, at least partially if not wholly, by three considerations:  1) APIE will have more flexibility and strategic opportunities to pursue growth, 2) the Texas medmal industry is structurally more favorable than in the past and AMPH will now reap the full benefits, and 3) the aforementioned financial accretion to AMPH shareholders.

 

The first two points are qualitative, but very important points.  APIE, because of the reciprocal structure, can't raise capital easily, restricting its growth opportunities.  For example, after an industry shakeout a few years ago in Texas medmal, pricing turned very favorable; while APIE benefited enormously, it couldn’t write as much business as it wanted to because it was capital-constrained.  As an incorporated subsidiary of AMPH, the insurance company will now be able to transfer capital in and out a lot easier.  The structural industry change is that Texas passed tort reform in 2003, and partly as a result, losses have dwindled and pricing began turning south about two years ago.  The very long-term impact of tort reform is still unknown, but it should mean that this downslope should be more benign than previous downturns, and the current overall cycle should be much more profitable than past cycles.  If AMPH owns APIE, its profits will no longer be capped by the profit-sharing formula, and AMPH should capture the incremental upside for itself.

 

 

VALUATION

 

The shareholder vote on the merger is on March 22, and AMPH will release 4Q earnings right after the vote date.  The stock popped on the merger announcement and has retained its gains, but I still don’t think that investors fully understand the accretion to current and long term earnings.  As the merged company reports its earnings, the stepped-up earning power should become clear.

 

After the merger, AMPH will have about $5/share in cash and still no debt.  It will have earned about $3.30 in 2006, or $2.40/share excluding favorable reserve development.  So the pro forma trailing P/E, backing out the cash and favorable reserve development is 5.4x.  Given current trends in medmal in Texas, I expect 2007 to be another good year, though certainly not as good as 2006.  AMPH could earn around $2/share pro forma in 2007, giving it a forward P/E of 6.5x.  Even assuming that we are on the downslope part of the cycle, this is too cheap.  Normalized earning power is probably around $1.50-2.00/share, so AMPH is trading at around 7-8x normalized EPS.  Just getting to a 10x P/E on normalized earnings would make this a $20-25 stock, and a more reasonable multiple would be 12x, or $23-29/share.

 

Catalyst

Closing of merger

Cheap
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    Description

    Back out the $8/share in net cash and American Physicians Service Group stock is cheap at a trailing P/E of 10x.  Better yet, it’s set to merge with a related company in a highly EPS accretive transaction, which makes the P/E drop to 5x.

     

    For further background, you can check out a timely previous post from another member two years ago.  I’ll first discuss AMPH as it looks today, and then talk about the implications of the pending merger.

     

     

    THE COMPANY TODAY

     

    AMPH is an extraordinarily profitable $49 million market cap company based in Austin, Texas.  It has two businesses, APS Insurance and APS Financial, both with high ROEs and great cash flow: if you back out the cash and securities from shareholders equity, AMPH has been earning over 100% ROEs for the past few years.  Historically, the two segments have each accounted for roughly half of AMPH’s earnings, but with the hard market in insurance the last couple of years, profits have been tilted heavily towards insurance.

     

    APS Insurance is the manager of Texas’s 3rd largest medical malpractice insurer, American Physicians Insurance Exchange, or APIE.  Note that APS is not an actual insurance company itself, it’s just the hired manager.  In legally specific terms, APIE is a reciprocal insurance exchange and APS is its attorney-in-fact, hired by APIE’s Board of Directors to manage the firm.  The crucial point for now is that APS Insurance takes on no direct underwriting risk; it simply receives a management fee off the top and also receives a profit-sharing fee.  This arrangement will disappear with the pending merger, so I won’t dwell on the details, but suffice it to say that this is an astonishingly profitable arrangement for APS Insurance, since not only does it have no risk to its capital, it has virtually no invested capital at all!  In 2005, APS Insurance reported $15.5 million in revenues and $5.3 mil in segment operating income.  The profit margins are even better than they look, since the revenues include over $4 million in pass-through commissions.

     

    APS Financial is a small, fixed-income focused securities brokerage firm.  AMPH entered this business in the early 1980s, hoping to cross-sell investment services to its doctor client base, but that strategy never panned out, and APS Financial eventually shifted its attention to institutional clients, which remain its bread and butter today.  It’s been quite profitable, with ROEs I’ve been told in the 20-25% range historically (the company doesn’t provide enough information for an outsider to confirm this).  However, the vast majority of its revenues are from bond trading commissions, which have been somewhat weak the past year or so.  With the environment only getting tougher, they’ve begun diversifying into asset management and investment banking, though both are still quite small.  In 2005, APS Financial reported $18.5 million in revenues and $2.3 million in segment operating income.

     

    The quick financial summary using September 30, 2006, figures is this.  AMPH has $23.6 million of cash and securities ($8.15/share on 2.9 million shares outstanding) and no debt.  It earned $0.96/share in the trailing 12 months excluding investment gains and interest income.  So backing out the cash from the today’s $17.50 stock price, you get a trailing P/E of 9.7x.  This is cheap, but the proposed merger discussed next makes the multiple look even cheaper.

     

     

    THE PROPOSED MERGER

     

    AMPH is proposing to acquire APIE, the medmal insurer that it manages, for about $39 million, mostly in AMPH stock.  The purchase price is 0.9x surplus.

     

    The deal’s strategic rationale makes sense.  AMPH has excess capital, while APIE is capital-constrained.  AMPH’s CEO Ken Shifrin is a smart and aggressive entrepreneur, and is reluctant to re-invest the excess cash in businesses he doesn’t know as well.  APIE, meanwhile, because of its unusual reciprocal exchange structure, can’t raise capital easily.  This combination solves both problems in one stroke.  There is absolutely no integration risk.  Not a single thing will change operationally after the deal closes – the same people will run it in the same way it’s been run before.  All the deal does is collapse the reciprocal/attorney-in-fact dual firm structure.

     

    The highlight of the deal, though, is that the profit accretion is enormous, both near-term and longer term.  AMPH will report somewhere around $1/share in earnings for the full year 2006.  Pro forma of the APIE merger, that will be more like $3.30/share of earnings!  Below are earnings before and pro forma the merger, excluding one-time gains.

     

                                                    2005                2006e              2007e

                Net Income                   $3.5 mil            $2.7 mil            $2.4 mil

                Shares Outst.                  2.9 mil              2.9 mil              2.9 mil

                EPS                              $1.20               $0.91               $0.82
     
                Net Income, pf             $12.3 mil          $16.5 mil          $10.0 mil
                Shares Outst. pf                5.0 mil              5.0 mil              5.0 mil
                EPS, pf                         $2.45               $3.30               $2.00

     

    The big pro forma accretion reflects the benefit of owning all of APIE’s profits, rather than just receiving a portion of it as a profit-sharing fee.  Under the current agreement, AMPH receives 50% of APIE’s net income, but it’s capped as a percentage of APIE’s gross earned premiums.  So in highly profitable years like 2005, 2006, and most likely 2007, AMPH caps out on the profit-sharing fee and misses out on the upside.  The total annual revenue AMPH has received from APIE has been flat at $11 million since 2004, even though APIE’s net income has tripled in that span, because APIE’s earned premium revenue has been flat.  In effect, AMPH has left multiple dollars of EPS on the table.  This deal should double AMPH’s normalized nearing power over a full cycle from $0.80-1.00/share to $1.50-2.00/share.

     

    There is one noteworthy negative to the deal for AMPH shareholders: AMPH will own an actual insurance company, so it’ll be exposed to all the capital needs and claims liabilities like any other insurer, nullifying its superb financial profile as an attorney-in-fact.  So all else equal, one should pay a lot lower multiple for a dollar of earnings from the new AMPH than for a dollar of earnings from the old AMPH.  However, this significant negative is offset, at least partially if not wholly, by three considerations:  1) APIE will have more flexibility and strategic opportunities to pursue growth, 2) the Texas medmal industry is structurally more favorable than in the past and AMPH will now reap the full benefits, and 3) the aforementioned financial accretion to AMPH shareholders.

     

    The first two points are qualitative, but very important points.  APIE, because of the reciprocal structure, can't raise capital easily, restricting its growth opportunities.  For example, after an industry shakeout a few years ago in Texas medmal, pricing turned very favorable; while APIE benefited enormously, it couldn’t write as much business as it wanted to because it was capital-constrained.  As an incorporated subsidiary of AMPH, the insurance company will now be able to transfer capital in and out a lot easier.  The structural industry change is that Texas passed tort reform in 2003, and partly as a result, losses have dwindled and pricing began turning south about two years ago.  The very long-term impact of tort reform is still unknown, but it should mean that this downslope should be more benign than previous downturns, and the current overall cycle should be much more profitable than past cycles.  If AMPH owns APIE, its profits will no longer be capped by the profit-sharing formula, and AMPH should capture the incremental upside for itself.

     

     

    VALUATION

     

    The shareholder vote on the merger is on March 22, and AMPH will release 4Q earnings right after the vote date.  The stock popped on the merger announcement and has retained its gains, but I still don’t think that investors fully understand the accretion to current and long term earnings.  As the merged company reports its earnings, the stepped-up earning power should become clear.

     

    After the merger, AMPH will have about $5/share in cash and still no debt.  It will have earned about $3.30 in 2006, or $2.40/share excluding favorable reserve development.  So the pro forma trailing P/E, backing out the cash and favorable reserve development is 5.4x.  Given current trends in medmal in Texas, I expect 2007 to be another good year, though certainly not as good as 2006.  AMPH could earn around $2/share pro forma in 2007, giving it a forward P/E of 6.5x.  Even assuming that we are on the downslope part of the cycle, this is too cheap.  Normalized earning power is probably around $1.50-2.00/share, so AMPH is trading at around 7-8x normalized EPS.  Just getting to a 10x P/E on normalized earnings would make this a $20-25 stock, and a more reasonable multiple would be 12x, or $23-29/share.

     

    Catalyst

    Closing of merger

    Cheap

    Messages


    SubjectQuestions
    Entry02/22/2007 01:23 PM
    Memberdavid101
    Abrams,

    Interesting situation but need some clarification:

    1. What will pro forma price/book and net written premiums to market cap be?

    2. Since APIE has no formal AM Best rating and part of the merger goal is to better capitalize APIE, how much of AMPH's cash will be downstreamed to the insurance sub?

    David

    Subjectreply
    Entry02/22/2007 03:36 PM
    Memberabrams705
    Greetings David,

    Pro forma book for Sep 2006 is $58.5 million, should be at least a few million higher by the merger close. The new market cap at current share price is $85 million. So the pro forma P/B is 1.3-1.4x. NWP in 2006 is around $59 million. The P/B compares favorably to the other public medmal companies, who all trade at 1.6x or so.

    Keep in mind also two things. One, AMPH post-merger is still not a pure insurance company, with 10-20% of the company a very profitable investment brokerage business, which would deserve a higher valuation multiple than medmal. Two, APS Insurance operates with negligible capital, so when you unite APIE and APS Insurance, the earning power is large in relation to book. Post-merger, insurance profits should accrue pretty quickly to book on a percentage basis, so the new AMPH deserves a higher multiple on current book than one would normally apply to a steady-state medmal insurer.

    AMPH hasn’t yet decided whether to downstream cash to the insurance sub; I think there’s a good chance that it won’t. It wants to balance returns on capital with the potential revenue benefits of getting a rating, and the timing isn’t right given the declining premium rates. Best would probably give it somewhere around a B rating right now, and I think if conditions remain benign, it could climb another notch or two as the surplus grows naturally.

    SubjectMore Questions
    Entry02/22/2007 05:05 PM
    Memberdavid101
    Abrams,

    Have some more questions:

    1. Who are the #1 and #2 med mal insurers? Is that based on premium volume or doctors insured?

    2. It looks like APIE will convert to stock first and then receive the AMPH shares. It looks like doctors will own 40% of AMPH after the merger. Any thoughts on whether they will hold or flip?

    As far as P/B on APIE, I think the discount to its peers is somewhat justified by the relatively high underwriting ratio, which is close to 2.0.

    I am intrigued just because it is small, involves med mal insurance, Texas and a funky transaction, but I would like to know their plans for the cash.

    David

    SubjectDon't understand
    Entry02/22/2007 07:17 PM
    Membergrant387
    the transaction if the cash isn't going to be downstreamed to the "insurance sub." I thought you wrote that they have been capital constrained so it just seems straightforward that the cash gets pushed down. Now, that may not be a bad thing - but it's a key part of understanding how things are going to look after the txn.

    Subjectdavid reply
    Entry02/23/2007 08:28 AM
    Memberabrams705
    “Who are the #1 and #2 med mal insurers? Is that based on premium volume or doctors insured?”

    The Texas Medical Liability Trust is the big dog in Texas, with about three times the premiums of APIE. MedPro is #2.


    “It looks like APIE will convert to stock first and then receive the AMPH shares. It looks like doctors will own 40% of AMPH after the merger. Any thoughts on whether they will hold or flip?”

    Your guess is as good as mine. They do have a 180 day lockup. I’ve spoken to a couple of policyholders, and they have no idea as to what they’re going to do with the shares. If common wisdom regarding the investing prowess of doctors is to be believed, perhaps we should wait and see how they behave, and then do the opposite.


    “As far as P/B on APIE, I think the discount to its peers is somewhat justified by the relatively high underwriting ratio, which is close to 2.0.”

    No doubt APIE deserves a discount. It seems to me, though, that if you peel back a few layers, the gap is too big.

    Subjectgrant reply
    Entry02/23/2007 08:29 AM
    Memberabrams705
    Hi grant,

    I didn’t mean to imply that they have immediate use for more capital when I said they were capital-constrained. What the deal does is add capital flexibility, i.e. the option to raise capital in the future if it needed/wanted to (or conversely, dividend out excess capital if it were to have any, although that’s an unlikely scenario for a while). APIE doesn’t really need any more capital right now. They’re writing as much as they care to. But it could’ve used more capital a few years ago when rates were hardening and the industry was shedding capacity. If another such favorable scenario were to recur in the future, the new structure can handle capital inflows easily. Or if it wanted to make an acquisition, they could do it with the new structure, while that would’ve been very difficult under the reciprocal scenario.

    Subjectduff reply
    Entry02/23/2007 08:35 AM
    Memberabrams705
    Duff,

    The record is solid. Texas was as bad as any state several years ago during the medmal downturn, and APIE, while not unscathed, fared better than most because it didn’t chase business as recklessly. It lost almost 30% of its surplus peak to trough and managed to replenish it fairly quickly, while others lost more and/or took longer to recover. At one point, there were only four carriers left in the state (I think the number peaked at over 50). APIE also smartly got aggressive when the market turned and rates became favorable. I have no illusions that the vicious cycle is gone, but the last trough was especially brutal for various reasons, and the next one is unlikely to be quite as bad. Also, this next one should at least be tempered by the very beneficial tort reform. Perhaps also, AMPH will manage with a little more eye for the shareholders, since APIE is currently a purely physician-governed entity. In any case, when you make $3/share in good times, you can do quite unwell in the bad times and still average out to a respectable profit over a full cycle.
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