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Subject:  ACGL : A case study on security analysis PART4 Date:  9/3/2004  10:01 AM
Author:  DCFNewbie Number:  32948 of 46880

This is the 4th part of a 5 segment piece on Arch Capital Group Holding Ltd. (ACGL), this time focusing on growth and risk.

Updated values and quick summary:

Framework structure:

1) Valuation

2) Operational Reality

3) Company History/Background

4) Operational Growth/Risk

5) Establishing Price Target and/or exit conditions

1) Valuation

Trailing P/E = 7.59
Trailing FCF/EV = 1.69

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 = 0.12

2) Operational Reality

I will subdivide this section into:

(1)- Industry
(2)- Company operations
(2.1)- Small description
(2.2)- Management
(2.3)- Operational metrics
(2.4)- Company's equity makeup and balance sheet

This section's content can be found on a previous post:

3) Company History/Background

This section's content can be found on a previous post:

4) Operational Growth/Risk

This section focuses on the various risks and growth opportunities for both ACGL's business and the stockholders opportunity by itself. The risk section has a specific substructure:

(1)- Sector risks
(2)- Industry risks
(3)- Company operational risks:
(4)- Other risks

The structure is self-explanatory.

Moving on:

ACGL's growth perspectives are closely intertwined with its risks. The company presents a diversified array of adversities that may, in the future, significantly impact earnings and cash flow.


Sector risks:
-Interest rates.

Industry risks:
-Cyclicity associated with the "soft" and "hard" markets of the insurance business.

Company operational risks:
-Natural catastrophes that offset the obtained balance between received premiums and claim payments.

Other risks:
-Abuse of voting and decision making privileges by the preferred shares stockholders.
-Abusive options issuing in favor of the preferred shares stockholders.

There are other "negligible" risks, described in detail in the company's 10-K. But those are associated more with lost of key operational personnel or increase in the combined ratio due to the lack of underwriting efficiency. I will ignore those because, in the big picture, they aren't particularly relevant.

So lets focus on the risks listed above:

Interest rates: Since part of the (re)insurance business is investing the "insurance float" in bond market, equity market, currency market or any other investment vehicle, the increase in interest rates affects the return potential of those same investments. But since management as already stated that it is comfortable in investing in low risk/high income markets (like bonds), and since the investment activity is only a small part of ACGL's activity, this risk seems contained.

Cyclical nature: The insurance industry is characterized by having "soft" and "hard" cycles. Those cycles define the competitiveness of the market and subsequential average operating margins (or, in this case, combined ratios). There is no defined period for an insurance market cycle, it might last 2 years, it might last a full decade. Historically those cycles have been characterized as being of either an extreme degree of competition (where insurers would support underwriting losses to guarantee increase in "insurance float") or by a great deal of underwriting sobriety (refusing to underwrite policies that aren't profitable). We are currently in that last state, defined has a "hard" market. The main question is: when is it going to fade and give place to a more competitive "soft" market? The risk associated with the cyclical nature of the insurance industry is linked with the predictability of the operational efficiency (in this case the difference between forecasted combined ratio and real combined ratio). ACGL has continually stres