Description

I am recommending a short position in Montepelier Re (MRH) as I believe the stock should ultimately be worth between $10-$20, compared with its current price of $25, and the upside in the stock appears very limited. MRH is a Bermuda-based property catastrophe reinsurer which recently announced significant estimated losses from Hurricane Katrina of $450-$675 million, assuming the total industry insured losses from the storm are $30-$40 billion. Their share of the losses were much more than their peers and drove the stock down around 20% to current levels. However, I believe the downside is significantly greater than is currently being reflected in the stock price as explained below.

The key points are as follows:

(i) The announced range of losses represents a hit of $6.25-$9.38 per share (based on 72mm fully-diluted shares) to their 6/30/05 book value of $22.45 per share. This represents a book impairment of about 30-45%, resulting in estimated book value of around $13-$16 per share;

(ii) The Company announced in its press release that it purchases “only a limited amount of retrocession protection, which is expected to be exhausted in these circumstances”. This means that they have no reinsurance protection for themselves if the losses get worse than their current estimates. Importantly, their share of additional losses will likely get exponentially worse as the industry loss increases. For example, if they reinsured a client for all losses over $100 million and a $40bn event results in a loss of $150 million for their client, then MRH would have to pay them $50 million. If the industry loss increases by 25% and the client has now lost $188 million, MRH is now on the hook for $88 million, an increase of 60% over their initial loss estimate. This leverage can also be surmised from the Company’s press release as a $30 bn event = a $450 million loss, but a $40 bn event (33% higher than the low end) = a $675 million loss (50% higher than the low end). Most insurers and reinsurers purchase protection to manage risk and ensure that their losses from large events don’t spiral out of control -- in this case, MRH took a gamble and lost;

(iii) The latest estimates for the storm damage are $40-60 billion, with estimates steadily moving up. Therefore, given MRH’s range was based below the current industry view and since they do not have any reinsurance protection left, they could see their losses grow significantly above the high end of their range. If the losses are closer to $50-60 billion (Fitch is at $50bn and RMS is $40-60bn), MRH could easily see their losses grow to over $1 billion, which would be over a $14 per share hit to book value and leave the Company with just $8 of book value;

(iv) MRH’s initial estimates of their own losses are likely to be too low given they have every incentive to start with a low estimate and gradually increase it over time as the real losses are realized. This incentive exists as it will better position the Company with the rating agencies, their customers and the public equity markets in the short-run (when they raise capital) as they sort out the mess. Last year was a good example of this phenomenon, MRH’s initial estimate for last year’s hurricanes was $185-$235 million and now, they estimate the ultimate loss to be $270 million;

(v) With such a significant hit to the Company’s book value, a ratings downgrade is likely in the absence of a significant capital raise. The Company has already been put on ratings watch by S&P, Moody’s and Fitch. Given the critical importance of strong ratings to a reinsurer (if ratings go below A-, a reinsurance company can not write new business as insurance companies are unwilling place business with that reinsurer), the Company will likely need to raise equity capital to shore up its balance sheet. Given the uncertainty around the ultimate book value and the size of the capital required to replace the loss, I believe if a deal could get done at all, it will be at a significant discount to market;

(vi) Wall Street analysts have largely refused to turn bearish on the stock as their firms are more focused on the fees that will come from a potentially large equity deal;

(vii) The Company’s stock price is likely being supported by its stated dividend yield of 5.5%. Given the book value hit and the prospects for a capital raise, this dividend makes no sense and will almost certainly be cut;

(viii) Even without Katrina, it is possible the Company was not going to make much money in the 3rd quarter anyway given several significant cats in the quarter (European floods, Hurrican Dennis, numerous airline crashes, etc.) and the hurricane season still isn't over;

(ix) Finally, I believe investors will come to realize that the property cat business model produces very questionable returns with an extraordinary amount of risk and this should result in a downward re-rating of the stock on a price to book basis. Following its IPO in 2002, investors were lulled into good performance by MRH as no major catastrophes hit. Now with two major events in two years, the risks have become clear, and the Company has wiped out two years worth of earnings (even during a post-9/11 "hard market") and at least 30% of its book value.

Below I listed what I see as the range of likely outcomes for the stock. In terms of valuation, the stock was trading at 1.5x book value before Katrina. This multiple was above the peer average and mostly supported by the market’s view of high returns and high dividends (both of which are casualties of the storm). The stock has historically traded between 1.3x-1.6x book value (including the very hard market of 2002-2003). Even though we are again likely heading into a hard market, I think the Company should trade towards the low end of that range given the now obvious risks to their model and the prospects for a capital raise at a significant discount to market. In addition, it is worth noting that, even assuming a $60 billion industry loss, the insurance industry’s capital base is still much higher than it was following 9/11, making a prolonged turn in the insurance cycle very unlikely.


Company Estimates
Low Mid High Potential?
Total Industry Event (in $bn) $30 $35 $40 $50-60
Total Book Hit (in $mm) $450 $562 $675 $1,000
Per Share Hit $6.25 $7.81 $9.38 $13.89
% Hit to Book 28% 35% 42% 62%
Pro Forma Book Value $16.20 $14.64 $13.08 $8.56
Current Price / Book Value 1.6x 1.8x 2.0x 3.0x

Low Target Price to Book 1.3x 1.3x 1.3x 1.1x
High Target Price to Book 1.6x 1.6x 1.6x 1.4x

Low Target Price $21.06 $19.03 $17.00 $9.42
High Target Price $25.92 $23.42 $20.92 $12.00

Given the range of industry losses and possible MRH losses as well as the 1.3x–1.6x book value range, the likely outcomes for the stock range from $9.50 - $26 per share (in the $40-60bn industry loss case I assumed a lower valuation range of 1.1x – 1.4x, since the business will be ravaged). I think the most likely case is the high end of the Company’s range of losses and a 1.3x – 1.6x book value multiple, representing a price of $17 - $21, representing downside of 16-32% from current levels – although I think the bias is likely for things to turn out worse, certainly not better, than that outcome.

Catalyst

* Investors begin processing the enormity of the loss and the very high resulting valuation
* Loss estimates are increased
* Capital raise at a significant discount to market
* Downward re-rating of the stock’s multiple given the now obvious risks in the model