Description

HCI is a far better short than UVE, which was recently popularized in the Robin Hood conference. Both companies currently trade at similar BV and earnings multiples, but for UVE short to work out either major loss event needs to happen or the alleged fraudulent activities need to be proven. HCI short thesis is not dependent on either.

HCI’s growth train ran out of steam and the company now appears to be in the run-off mode with 15% annual net churn. A number of factors will drive disproportionately high declines in profitability in the upcoming quarters. I see fair value at 1xBV at most, equivalent to $20/share.

Background

HCI has already been written up by TR1898 back in 2013, so please refer to that write-up for more detailed industry/company background. Additionally, there is a very good coverage by RH Analytics on SA (Wizards of Tampa series from Sep/Oct 2014). This post will focus mostly on what has changed since TR1898 write-up and why it is a timely short now.

Background in a nutshell: HCI Group is P&C insurer with the whole portfolio concentrated on Florida wind policies. Florida wind insurers seem to be at a peak of the bull cycle on the back of no major loss events for the last ten years. HCI has been growing and overearning as a result of Citizens (the state owned insurer) depopulation. Policies assumed from Citizens were profitable due to zero acquisition costs as well as no reinsurance required till the start of the hurricane season. Competition among domestic insurers has intensified and the pool of Citizens policies that can be taken-out profitably has been exhausted. Organic growth is non-existent and without Citizens’ take-outs HCI will continue to decline at 15% annual churn. The company currently trades at 1.9xBV, although as the latest quarter showed that high ROEs (30%+) are unlikely to be replicated going forward.

No organic growth. Citizens take-out pool is exhausted

HCI stands out among its peers as the only company which hardly does any new business organically and is fully reliant on Citizens policy take-outs to maintain and grow its portfolio. Since 2009 the company has written only 10k new policies, but during the same period it acquired 162k policies through take-outs and 68k through HomeWise portfolio assumption in 2011. HCI does not even write new policies internally and seems to direct all the traffic to the selected agents.

When it comes to the potential for further take-outs from Citizens, the pool is now fully exhausted. This is where the previous VIC write-up was too early. Subsequent to it, HCI announced further take-outs and added a total of 76k policies till today (out of 163k currently outstanding). But now the situation is materially different compared to the one couple years back:

• The number of policies in Citizen’s pool stands at 534k vs 1223k two years ago. The remaining ones are likely to be the most risky policies that no private insurer wanted. During 2015 alone take-out companies were awarded 974k Citizens policies (out of 661k outstanding at the beginning of the year) to sift through before choosing which ones to assume – meaning that all the remaining Citizens’ policies have already been looked at and rejected several times.
• The percentage of Citizens policies that have been assumed relative to the awarded ones has been gradually decreasing over the recent years. It stood at 63% in 2012, 43% in 2013, 37% in 2014 and only 23% in YTD 2015. So even with the added benefit of no reinsurance and no customer acquisition costs, the Citizens pool is becoming less and less attractive to private insurers. The same figures for HCI show even sharper drop – 80% in 2012, 69% in 2013, 53% in 2014 and then only 7% in 2015.
• The proportion of coastal accounts (the most risky and the least profitable ones, previously considered uninsurable by private sector) out of the total assumed has gradually increased from 9% in 2012 to 35% in 2015. In the latest three HCI take-outs, these riskier policies comprised 87%, 49% and 100%. Thus, as Citizens pool is getting more and more exhausted, take-out companies are forced to increase their risk tolerance and even then hardly find any suitable policies.
• In the latest take-out (Oct 2015) HCI did not assume a single non-coastal policy out of 21k it was awarded.

These stats clearly indicate that the growth from the take-outs is finished. Paresh Patel (CEO of HCI) confirmed that much during Q4 2014 conference call “That’s not at some point in time, I think we are pretty much there now”. When prompted on how HCI will continue going forward, his response was even better:

“To that point, I think, the future growth that we will have, I suspect, is going to be in a same way that we always had it, is that, there will be -- sitting here one day and an opportunity will show up and it has happened consistently is just that it is unpredictable. So our future growth I think is going to come along those lines”. 

Fantastic business plan for half a billion dollar company.

Three quarters later that opportunity apparently has not shown up yet and Mr. Patel had to play the take-out card again: “So I think the takeout business is not bad yet, is sitting in ICU and there's like priests in the room“. By ‘not bad yet’, he mean HCI was able to find 2.7k policies out of 52k awarded – miserable impact for a company that is losing 6k policies every quarter.

5% cut in premiums during 2016 just to maintain the retention at current levels

In Q3 conference call management announced 5% cut in premiums. This will affect 2/3 of the book upon policy renewal during 2016. Management was vague in revealing the reasons for such a move, but it seems competitive pressures are building up: “better take a few preemptive steps than reactive steps when your retention starts moving in the wrong direction“. Interestingly, management stated that retention is not expected to improve due to this pricing change, but merely stay at the current levels – i.e. the run-off mode will continue.

This cut in pricing will have disproportionate effect on profitability. Gross premiums earned will decline by $14m (5% x $280m book of homeowners policies) and all of it will flow through directly to the bottom line. $14m is equivalent to 15% of TTM pre-tax profit and likely an even bigger portion (>30%) of next year’s pre-tax earnings. As the pricing cut will be carried out through policy renewals, the full impact will be evident by Q4 2016.

Wind-only policies erode profitability

HCI has assumed a bunch (34k) of coastal accounts (majority being wind-only policies) in Q4 2014 and Q1 2015. As mentioned above, these policies are considered to be the most risky ones and other insurers (with exception of HRTG) have shown limited interest in taking these off Citizens’ books. The profitability impact of these policies was not visible during H1 due to minimal claims and reinsurance requirements during the hurricane off-season. But Q3 results showed the true cost of holding coastal accounts in the portfolio. Reinsurance cost went up from 31% to 40% of gross premiums and loss ratio increased from 36% to 42%. As a result net profit dropped by 50% (equivalent to annualized ROE of 12%). 

These profitability levels are likely to be the new normal due to higher riskiness of the book, but management downplayed the importance of the decline by attributing it to one-time factors:

• Loss ratio increased due to heavy rains in Florida. Interestingly, last year (Q3 2014) when loss ratio went up from 27% to 36%, management partially explained it by the severity of fire related claims. Somehow the positive YoY effect from lack of fires this year was muted. Also none of the other listed domestic insurers (except HRTG, which has also taken ) even mentioned the impact of heavy rains and none had their loss ratios affected to similar degree.
• Higher prior period adjustment accounted for 1/3 of the change in loss ratio. Historically, HCI had significantly lower loss ratios than its listed peers (with exception of UVE, which is now being accused by investors of under-reserving and not paying out claims). So it remains to be seen whether the adjustment this quarter was one-off or a beginning of the new pattern that will bring HCI loss ratio in line with peers.
• Higher ratio of ceded premiums was explained by being overly cautious with regards to wind-only book. If anything this management team is known for being overly aggressive rather than cautious, so their statement should be taken with the grain of salt. Besides, HRTG which also took on exposure to coastal accounts saw the ceded premiums go up as well (from 30% to 35%).

When asked about the profitability of the wind-only policies, management declined to comment. But looking through at incremental costs YoY it appears that wind-only policies are actually loss making (these were profitable only in H1 2015). Even if as management suggests the cost structure in Q3 was elevated due to one-off factors or over-cautiousness, the wind-only policies are break-even at best.

Valuation

With no further meaningful take-outs from Citizens, the company will likely continue losing the customers at double digit rate. So far HCI managed to claim YoY growth, but starting with Q4 2015 the policy count and net premiums earned will be officially in decline. Reinsurance costs on wind-only policies will add a further pressure on YoY profitability comparisons in Q1 and Q2 of 2016. And then on top of that there will be 5% pricing reduction on 2/3 of the book. Basically, as far as financial figures are concerned the company will be facing deterioration on both top line and bottom line at least for the next few quarters. 

Assuming the cost structure will be in line with the Q3 results and historical net churn of 15% will prevail, I have the company generating net income of $23m (ROE=10%) in 2016 and $13m in 2017. With these levels of declining earnings the market cap of $430m and valuation of 1.9xBV look ridiculous.

Even with overly optimistic assumptions of 10% churn (improved due to pricing decline), reinsurance costs lowered to 35% and loss expenses in line with TTM average (21% of gross premiums), HCI would earn $47m in 2016 and then $36m in 2017. So the company in the run-off mode is currently trading at 10x next year earnings of a very optimistic scenario. On top of that these earning estimates completely ignore any risk of major catastrophe event.

The bottom line is that with the business declines set for the upcoming years HCI is sort of a liquidation story and as such the fair value is somewhat below 1xBV.

Risks

The biggest risk is that HCI somehow manages to stop the churn that has been happening for the last 7 years and start growing the business organically. In a commoditized home insurance market this would demand far higher pricing cuts than the planned 5% as well as investments in marketing/distribution channels and higher customer acquisition costs – all of which will depress REOs and will likely make the current 1.9xBV seem undeserved even no churn.

HCIs management is continuously promising new ‘growth of tomorrow’ story every single quarter. These ranged from potential M&A opportunities to real estate and technology investments, flood insurance and expansion to other states. Usually one of these topics is the focus of a particular earnings conference call and then fades out in the upcoming ones. So far none of these endeavors produced the expected results or gained any meaningful traction. With every try to find a new growth avenue it becomes more and more evident that Citizen’s take-out was the only thing that HCI could do.

The final point relates back to UVE. If the fraud allegations turn out to be true and UVE goes belly up, then HCI would be one of the potential acquirers of its portfolio. Back in 2011 HCI assumed HomeWise portfolio out of liquidation, however the current competitive situation is far more intense and UVE’s portfolio is unlikely to be a free handout.

Catalyst

Deteriorating financials in the upcoming quarters

Q4 2015 negative YoY comparisons for policy count and earned premiums.

Any major catastrophe event would come as a bonus