This isn’t a “banging the table I’ve found the worlds greatest investment” writeup. Instead, it’s a “why is this thing so cheap” writeup. Specifically this idea is likely outside of my tiny circle of competence, and I’m looking to members wiser in the ways of the insurance business to slap me silly before I commit a major portion of my capital to this one. This writeup is also mostly from memory, I was close to writing it up a month ago but it got expensive, now it’s gotten cheap again so I’m quickly shooting this out while it’s timely.
Quanta Capital is a lousy Bermuda based specialty and re-insurance insurer started after 2001 that in it’s brief history never made money. After being bitchslapped by last years hurricanes, and two ratings downgrades, Quanta decided put almost it’s entire business into run-off. Most of it’s remaining cash is in subs, and it will take time for management to extract that cash to the holding company level where it can be available to shareholders.
Why is it interesting? The common is trading at about half of book value (that is mostly investments), so if you believe it’s loss reserves are anywhere near accurate, the common is a potential double. But given the companies woeful record for pricing and reserving their insurance products, that’s a pretty risky play. But much better, it has preferred shares that offer a much safer investment, and are trading at an even better discount to liquidation value.
Let’s look at what Quanta’s tangible book value could look like a year from now, assuming no increase in loss reserves.
Shareholder Equity (Q1 2006) $367,065
Premium Refunds $(16,000)
Unrealized Losses $(6,100)
Def Aquisition Costs $(28,718)
Other Assets $(22,489)
1 year burn $(28,000)
Lease Writedowns $(10,000)
ESC Value $36,000
Historical Loss Ratio $(37,962)
Tangible Equity $220,979
Per Share $3.16
Here are my assumptions. My severance number is based on last quarters cut of 80 employees and applying the same per employee severance to the remaining employees. This is overly conservative because Quanta isn’t going to lay off everyone, in fact it will keep two businesses active, ESC, an environmental services arm and it’s Lloyds of London business. The CFO on the Q1 conference call mentioned “we have, or we expect to, return gross premiums of $16M”. Now some of this may have been accounted for in Q1, since I’m not sure how much, I decided to deduct the full amount. I also used their historical loss ratio against pending business.
Currently QNTA is trading at $2.28 or over a 25% discount to potentially realizable book value, probably not cheap enough, given this managements history. But the preferred shares (QNTAP) are trading at $17.38, over a 30% discount, and given it’s position in the capital structure, offering a much less downside. Essentially
The preferred was issued at the end of 2005 to shore up Quanta’s capital position, back when management thought they still had a business to shore up. It nominally pays $2.56 a year in dividends, but dividends have now been suspended because Quanta is in default on the terms of it’s credit facility (due to it’s rating decline). So it’s unlikely to pay or accrue dividends for a number of quarters going forward. The preferred is pretty weak, it’s not convertible into common, and has no right to even accrue dividends. But dividends must be resumed before common can be paid any (cash) dividends, must be redeemed in any change of control or liquidation, and if dividends aren’t paid for 6 quarters, preferred has the right to elect two directors to the board.
I don’t think management wants preferred shareholders on the board. I believe they want to cleanup the mess and direct some of the excess cash to common shareholders, while selling or still operating their two remaining businesses. So my thesis is that management has one and a half years to clean up the insurance subsidiaries, move cash up to the holding company level, eliminate it’s default on it’s credit facility, and resume preferred dividends (or retire the preferred). Today’s price is offering a 44% return over that period, and when dividends resume it will yield 15% against todays purchase price.
Also shorting the common may offer an interesting hedge for those who like that sort of thing. If common turns out to be worth zero, you could win on both trades.
Risks/Issues: The big risk is that the balance sheet is illusionary and more big claims come through. I’m betting that by now, most of their big losses from last years hurricanes have been properly reserved for. The other risk is that they don’t get paid by their reinsurers. Their current tangible assets are about $1.55B, including $108M is reinsurance, and $1.02B in investments, cash and restricted cash. Their average reinsurer is rated A. Essentially with $592M in loss reserves, the preferred remains whole as long as loss reserves aren’t increased more than 35% (assuming the other cash burn in my forecast is accurate).
Another issue is that the preferred is relatively illiquid, market cap for the preferred is only about $50M, and most days trades only a few hundred or thousand shares. But every week or two, it appears a large block is being sold, as many as a hundred thousand shares or more, so it appears shares are available if you know how to find them.
For those who care about who else is invested in their ideas, Quanta has a bonafide rock star on it’s shareholder’s list, Seth Klarman’s Bauhaus group. They have been an owner of the common earlier this year. Not sure if they owned any preferred or whether they are still holding.
Lastly, I have no position here yet. I’m fully invested in a bunch of other lousy ideas, though I’m trying to pickup a small amount of shares opportunistically as cash frees up in my accounts.