Mercer Insurance Group MIGP
April 30, 2008 - 10:29am EST by
david101
2008 2009
Price: 16.82 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 113 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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  • Insurance
  • Discount to Tangible Book
  • Demutualization

Description

Mercer trades at 88% of tangible book value (TBV) and less than 9X 2008 earnings. It is now cheaper than when I originally submitted this idea four years ago.

 

I will not delve into the background details, as you can read about it my previous write-up and the subsequent write-up by Raf698:

 

http://www.valueinvestorsclub.com/value2/VIC/members/view-thread.aspx?id=1366

http://www.valueinvestorsclub.com/value2/VIC/members/view-thread.aspx?id=1833

 

I will focus on the Financial Pacific acquisition, the investment portfolio and estimated earnings.

 

Financial Pacific (FP): As noted in the threads of the previous write-ups, a decently priced acquisition made sense for Mercer to deploy its IPO capital. Mercer did not over pay for FP and, based on performance to date, it has been accretive. What is interesting is how the FP acquisition transformed Mercer. As of 2004, annual net written premiums (NWP) for both insurers were roughly the same at around $55 million. The key difference was that FP had $107 million of direct written premium (DWP), before reinsurance, in 2004, so it was ceding almost half their premiums. With the financial strength of Mercer behind it, FP was able to retain more premiums.

 

Mercer had $66 million of DWP in 2004. If you combine it with FP, their pro forma 2004 DWP is $173 million. DWP for 2007 was $182 million. This is important to highlight. If you look at the 10-K figures for net premiums earned (NPE) from 2004 to 2007, it looks like a massive growth spurt. If this were a widget manufacturer, it would look great, but for insurance, significant growth is viewed with suspicion. Fast growth in insurance often implies willy nilly underwriting that will eventually catch up to a company. What I am trying to say here is that their underwriting has been fairly consistent, they have retained customers and completed the integration in an orderly fashion. These are good things to see in an insurer.

 

Investments: The credit crisis and the turmoil in the bond market have created concerns for all insurers, as they typically hold a lot of bonds in their investment portfolio. First, there are no CDO sub-prime holdings. Equity investments represent only 5% of the portfolio. Mortgage-backed securities (MBS) make up 25% of the portfolio but they are all government or government agency paper. One issue is the credit enhancement on their municipal bond portfolio. Of the approximately $144 million of muni bonds held by Mercer, $102 million were credit enhanced. In their 4th Quarter earnings release, Mercer showed how removing the credit enhancement would lower the average rating on the municipal bonds from “AAA-“ to “AA.” There is some added risk for potential defaults down the road, and a hit to OCI, but it would have to be significant to impact earnings and book value. Average duration on the portfolio is 3.5 years and average yield, including cash, is 3.9 %. Excluding the MBS, duration is 5.9 years.

 

Geographic Risk: While the FP acquisition allowed Mercer to diversify away from NJ, it now has a lot of West Coast exposure, as evidenced by 2007 DWP for its largest states:

 

CA  54.7%

NJ  26.7%

PA 7.2%

NV  6.4%

AZ  3.4%

OR 1.5%

 

 

Institutional Support: The recently filed proxy showed the following 5%+ owners:

 

- FMR 10.1%

- DFA 8.0%

- Thomas David 5.7% (He sold Franklin Insurance to Mercer and received 500K shares at the IPO for the remainder of Franklin)

- Mercer ESOP 9.6%

 

Share Count: I used 6.7 million shares as the diluted shares outstanding to be conservative. The number of treasury shares is very close to the number of shares for stock options and restricted stock. The company did recently announce a 5% buyback and raised the dividend to $0.075/quarter.

 

Combined Ratio: For 2006 and 2007, the combined ratio has been 98.3% and 95.8% on a GAAP basis and 95.2% and 94.4% on a statutory basis, respectively. Note that the 2007 GAAP combined ratio was adjusted to exclude the premium tax refund, plus interest, received last year. When I first wrote up Mercer, the expense ratio was 44% and last year it was 36.0% on a GAAP basis and excluding the refund. A big driver behind that drop is the leveraging of premiums against its fixed costs. Expenses were actually up in 2007, as the 2006 expense ratio was 33.3%. The increased expenses stem from increased technology costs (more on that later). Out of the last ten years, the combined ratio has only pierced 100% twice, in 1997 and 2003, and that was largely driven by storm losses in personal lines.

 

Earnings: There are two things that will help drive earnings up in 2008 and 2009. One is the introduction of a new online quote system for commercial lines. This has a two-fold impact, as development costs should decrease in 2008, thus lowering expenses, and it should increase premium growth. The second factor that will help earnings is that Mercer is expanding its product offerings by offering unique Mercer products through FP and visa versa. Most of these items will show up in Net Written Premium (NWP). Net earned premiums will be largely influenced by 2007 NWP, which was $159.6 million. Below is my estimate for 2008:

 

 Revenue:

2008E

 Net premiums Written

155,000

 Net premiums earned

149,000

 Investment income, net

12,500

 Net realized inv. gains

0

 Other revenue

2,000

 Total revenue

163,500

 

 

 Expenses:

 

 Losses and loss adj. exp.

92,400

 Amortization of DAC

39,400

 Other expenses

12,000

 Interest expense

1,215

 Total expenses

145,015

 Undewriting Income

5,985

 Income before inc. taxes

18,485

 Income taxes

5,365

 

 

 Net income

13,120

 Earnings per Share

              1.96

 2008 P/E Mulitple

                8.6

 

 

 Investment Portfolio

340,000

 Equities

17,000

 Total Investment Portfolio

357,000

 Return on Inv. Portfolio

3.5%

 GAAP Loss Ratio

62.0%

 GAAP Combined Ratio

96.5%

 Income Tax Rate

29.0%

 

 

I have tried to be conservative by keeping investment income lower in 2008 and showing a decline in NWP, as the gains in the new products and the new system may be offset by loss of business. P&C pricing has gotten soft and Mercer may let some business walk rather than write it unprofitably.

 

Key Banc and Keefe Bruyette provide the only Street coverage on Mercer and they are estimating 2008 EPS at $2.15 and 2009 EPS at $2.43.

 

Risks:

-        A major catastrophe impacts results

-        Loss ratio increases

-        Management compensation continues to creep up

Catalyst

- Cheap
- New products drive growth
- Reduced expenses
- Buybacks
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