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|Subject: ACGL : A case study on security analysis PART2||Date: 8/29/2004 7:47 PM|
|Author: DCFNewbie||Number: 32862 of 46865|
Before I continue with this analysis I would like to recall a few important points:
First of all, the main goal of this exercise is for other Foolish Collective members to help me fine tune my analysis process.
The second objective is to come up with a simple framework for beginners like me to adopt in the search for "value plays". I intend to submit that framework to the "101(A): Equity Analysis basics" initiative for further debating.
Summing up the last thread:
2) Operational Reality
3) Company History/Background
4) Operational Growth/Risk
5) Establishing Price Target and/or exit conditions
Trailing P/E = 7.06
Trailing FCF/EV = 1.49
Analysts Growth Est. (5yr) = 20%
Past Growth (5yr) = 8.9%
Industry predicted growth (5yr) = 12.4%
Pondered growth average (20+8.9+10.95)/3 = 13.77% <- This one is the one I'll be using
We will try and justify how reasonable this growth is in section 4 - Operational growth and risk
FCF/EV/G = 0.11
Moving on :
2) Operational Reality
I will subdivided this section into:
- Company operations
- Small description
- Operational metrics
- Company's equity makeup and balance sheet
I'll try to avoid mentioning the company's history since I believe it deserves a section of its own. That will setup ground for the fourth section which is called "Operational Growth/Risk". And that will give us the final data for "Establishing Price Target and/or Exit Conditions".
So here you have my take on the company's operations and its particularities:
- The industry:
Arch Capital Group Ltd. is a holding company specialized in the insurance and reinsurance business. Most importantly it's a Bermuda based (re)insurance (both an insurer and reinsurer). As history has it, immediately after 9/11, a large number of small and mid-sized insurance companies went bankrupt. That event exposed one big problem in the insurance industry: the lack of ability to deal with low probability/high impact events.
Bermuda based reinsurance companies were born mainly with one objective in mind: to take advantage of the specificics of the tax regulation that heavily favors operations by insurers and reinsurers. There is no question that the best place for a small to mid-size (re)insurer to be based is in Bermuda. Although there were already some (re)insurers in Bermuda pre 9/11 there was a definite boom after that.
While insurance is a common sense activity, I believe that the act of reinsurance deserves clarification.
Reinsurance is the act of spreading risk vertically through out the insurance industry by having other companies take on some of the risk associated with the polices (End customer -> Insurance Company -> Reinsurance Company -> Reinsurance Company -> ...). Likewise the premium is also distributed vertically through the reinsurance trail or just sold form one company to another. Interestingly enough, one of the most important part of the reinsurance business is the back and forth of buying and selling of policies between reinsurers according to each's assessment of risk and return.
So the main idea behind the operations of a reinsurance company is the correct assessment of risk and subsequent acquisition of policies who are undervalued according to that same assessment.
One important factor in all of this is that the returns associated with a (re)insurer aren't only associated with the mathematical assessment of risk and return, they are also defined by the risk psychology that affects policy prices. The fear associated with terrorist attacks for instances over inflates the real economic risk. The insurance industry feeds on that fear to increase policy values.
When a major disaster occurs (re)insurers with incorrect risk diversification can go bankrupt, but, on the upside, those that survive can harvest the increase in the value of written premiums.
A (re)insurance company is essentially about two things: Having the smallest combined ratio possible and getting the best returns out of the investment of the "insurance float".
Combined ratio is a sort of operational gauge applied to the underwriting process. Instead of behaving as a standard margin measurement, the break even point is 100%. Anything bellow signifies profit in the same proportion, anything above means the opposite.
Investment is another big part of the insurance business. Between the time the premiums are collected and insurances are claimed that money can be invested (insurance float). But that investment cannot be made in operations (at least not without substantial safety margins), the need to keep large reserves (specially associated with catastrophe insuring) favors low risk/high liquidity investments.
There is no significant barrier to entry in the (re)insurance business so differentiation is all about management and capital. So the big question is: what companies are undervalued (if any) and which are in the best position to maximize the return to a fairer valuation.
- Company operations:
Arch Capital is in a good position for several reasons. First it seems to have a better cash flow generation ability than most and second, it has a above average management experience.
It's headed by Constantine Iordanou (CEO), who before coming to Arch Capital in the beginning of 2001 was the president for the commercial casualty division at Berkshire Hathaway. He also occupied several top management positions at Zurich Financial Services (mainly insurance operations related) and a vice president position for a subsidiary of American International Group. Other managers have resumes that include stays at General Re Corporation, WR Berkley Re and other popular insurers and reinsurers.
ACGL's combined ratio is continuously decreasing:
06/2002 - 92.5%
09/2002 - 91.0%
12/2002 - 90.2%
03/2003 - 88.2%
06/2003 - 90.7%
09/2003 - 89.1%
12/2003 - 89.0%
03/2004 - 88.8%
06/2004 - 87.8%
Although past performance doesn't guarantee future results, it does give an indication of a trend.
Return on equity is seeing a good increase too:
1999 - (10.2%)
2000 - (2.9%)
2001 - 2.2%
2002 - 3.9%
2003 - 16.4%
2004 - 18.4% (estimate)
Once again validating increasing efficiency on operations.
The return of non-operational investment has contributed only partially to ACGL's income. It seems clear that management is more worried in improving operational efficiency than dramatically increasing the companies dependence on investment income. That is compatible with the degree of maturity of ACGL (unlike a full grown insurer like Berkshire Hathaway or American International Group).
That said, investment returns are growing:
09/2002 - $14.9M
12/2002 - $16.0M
03/2003 - $18.4M
06/2003 - $19.8M
09/2003 - $20.5M
12/2003 - $22.3M
03/2004 - $24.6M
06/2004 - $32.8M
And now make up about 25% of total returns.
Free Cash Flow as also evolved quite nicely overtime:
2000 - $7.5M
2001 - $2.6M
2002 - ($5.6M)
2003 - $1612M
2004 - $1800M (estimated, with $944M so far)
"The significant increase in cash flow was primarily due to the substantial growth in premiums written and collected and a low level of claim payments. "
That cash flow is what, in time, allows growth in "insurance float" as well as book value.
- Company's equity makeup and balance sheet:
Common Shares: 33.5M
Preferred Shares: 38.4M
Total Shares: 71.9M
Enterprise Value: 2.71B
Market Cap. : 2.60B
53% of equity is non public. It's in the form of preferred shares issued to the original investors: Warburg Pincus LLC, Hellman & Friedman LLC and negligent amounts to others, at the last capital infusion (763 million back in November 2001).
Both Warburg Pincus and Hellman & Friedman have directors in ACGL's board. Since, according to ACGL:
"Pursuant to a shareholders agreement that we entered into in connection with the November 2001 capital infusion, we have agreed not to declare any dividend or make any other distribution on our common shares, and not to repurchase any common shares, until we have repurchased from funds affiliated with Warburg Pincus LLC ("Warburg Pincus funds"), funds affiliated with Hellman & Friedman LLC ("Hellman & Friedman funds") and the other holders of our preference shares, pro rata, on the basis of the amount of each of these shareholders' investment in us at the time of such repurchase, preference shares having an aggregate value of $250.0 million, at a per share price acceptable to these shareholders."
That basicaly means that its up to management to decide at which price the shares should be bought back. For all purposes diluted values according to the company assume that preferred shares have the same value as common shares.
So there. This is, to the best of my ability, the best description of ACGL's current operations. I tried my best to give a detailed but short description. If someone wants to sugest changes or another path into the part of the framework that describes a company's operations, I would be very interested in hearing about it.
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