Primerica: Earnings Growth Regardless of the Economy
Jul/102
Primerica (NYSE: PRI - $20.98)
Introduction
I recently purchased shares of Primerica, which is a life insurance and mutual fund marketing company. Primerica was recently IPO’d by Citigroup (C) as part of Citi’s balance sheet reduction program. It has been one of the best performing IPO’s of the year so far. I believe Primerica’s shares are undervalued because investors are not factoring earnings growth that will be stronger than published Street expectations.
Company Background
Primerica provides financial products and services to middle-market America through a salesforce of independent producers. The company’s two main products are term life insurance and 3rd-party mutual funds. The company was formerly run by the legendary salesman A.L. Williams, who used inspiring motivational speeches to energize the salesforce. Sandy Weil bought the company in the early days of creating his Citigroup empire.
Main Investment Thesis
My main investment thesis is the current valuation does not factor earnings growth that will be stronger than the Street’s published expectations.
Why do I think earnings growth will be stronger than the Street estimates?
Prior to the IPO on April 1, 2010, Primerica entered into a reinsurance transaction with Citigroup that took about 80% of Primerica’s existing term insurance book off of its balance sheet and put it onto Citi’s balance sheet. This dropped the existing term life in-force block to drop from $650 billion to $130 billion. This also caused a one-time step down in Primerica’s earnings from to a $500 million annual run-rate to a $150 million annual run rate. Going forward, Primerica still has the same salesforce that was selling enough term life policies to grow a $650 billion term life block 3% annually. This salesforce producing the same amount of business can grow a $130 billion term life block at 51% annually.
How does 3% growth become 51% growth?
Primerica’s reinsurance transaction with Citigroup reduced the company’s existing block of term life insurance from $650 billion to $130 billion, but it did not diminish the capabilities of the company’s salesforce from adding new policies. In 2009, Primerica had a 10% lapse rate on its term life policies and added $80 billion in new term life policies. This led to a 3% growth rate.
In 2010, if will assume a continuation of the 10% lapse rate and another $80 billion of new term policies, the new $130 billion block of term life policies will grow to $197 billion or a 51% growth rate.
How does this growth translate into earnings?
The term life insurance division accounts for about 60% of the pre-tax earnings. I think this segment can grow 40% in 2011. The mutual fund sales can grow 5% a year, which assumes no in-flows and 5% market appreciation. Combined, I believe earnings in 2011 can be north $2.40 for a growth rate of over 20%.
Why don’t investors see this potential earnings growth?
Primerica’s potential earnings growth is hard to see because the reinsurance transaction with Citigroup is confusing and not what investors normally encounter.
Does Primerica have the capital available to support this level of growth?
Yes, Primerica has extra capital currently. The risk-based capital ratio is estimated to be north of 450%. Plus, the mutual fund savings division generates capital equal to its net income because it does not need capital for growth. Lastly, Primerica is only going to pay a token dividend while it is in this high growth mode.
Other Positive Parts of the Primerica Story
Plain vanilla business with no legacy issues – Primerica’s business is simple to understand. It is mainly a salesforce distributing straightforward term life insurance and a 3rd party mund funds. Term life insurance is one of the easiest forms of insurance for a life insurance company to manage on its balance sheet.
Potential for management to respond to improved incentives – Primerica’s management team should be motivated to show good results out of the gate from the IPO. This is an organization built on motivation and financial incentives. When the company was a subsidiary of Citigroup, I’m sure management had financial incentives, but the were still paid partly with options on Citigroup overall. It was impossible for them to move the needle on Citigroup’s stock. Now as an independent company, Primerica’s management team can directly impact the stock price by delivering strong results.
Ownership presence of Warburg Pincus – As minority shareholders, we are helped by Warburg Pincus’s ownership stake and presence on the board of directors. We can expect Warburg Pincus to focus on shareholders returns. With Warburg’s presence, we also expect management compensation to be under control and expect no value destroying acquisitions.
Leverage will add to returns – As part of the spin-off from Citigroup, Primerica took on some modest leverage at the holding company level that will improve equity returns. Since Primerica’s business seems stable and cash producing, I am comfortable the modest leverage will enhance returns without adding to the risk of financial distress.
Valuation
I believe Primerica is undervalued. At $21 per share, Primerica trades at 1.4x tangible book value and 9.5x the Street’s 2011 EPS estimates. These valuations are in-line with their life insurance peers. However, I believe the Primerica story is cleaner than the rest of the industry because they have fewer legacy issues (such as the investment portfolio at Aflac (AFL) or commercial real estate at Principal (PFG)) and are not dependent on the stock market for earnings growth (such as Prudential (PRU), Ameriprise (AMP), Hartford (HIG) or Lincoln (LNC)) Plus, with the reinsurance transaction with Citi, Primerica will have attractive growth for the next 5 years.
In addition, I believe Primerica could earn as much as $2.40 (or 22 cents more than consensus estimates) in 2011 as they regrow their term life book. As analysts increase estimates, the stock may attract attention from investors attracted to companies with rising estimates. The stock’s multiple could rise to 12x leading to a $29 stock price.
Risks
The main risks to my investment thesis on Primerica are: 1) I am overestimating the potential for earnings growth and 2) the market already recognizes the potential earnings growth and has appropriately priced the stock.
Primerica does have at least one potential issue with a reinsurance company facing financial difficulty. It has about $50 million reinsurance recoverable exposure to Scottish Re, which is in run-off. If they had to write-off this amount, it would be equal to a quarter of earnings. I believe the market would look through this issue if it happened.
I discount some commentators’ views that the Primerica salesforce is a risk. I believe the Primerica salesforce is a vital asset of the company. Yes, they recruit heavily and have high churn, but financial sales is not easy and not every recruit is able to make in sales. I think of Primerica’s salesforce as similar to Aflac’s. Both are high energy, depend on multi-level principles and have high turnover. While I wouldn’t succeed as a Primerica salesman, I admire the results of the organization. As Phil Fisher wrote, you want to own companies with outstanding salesforces.
Conclusion
I purchased shares of Primerica recently because I believe the shares do not factor in the potential earnings growth of the company. The business is a plain vanilla term life insurance business with some 3rd-party mutual fund sales. The earnings growth is not dependent on the stock market improving, rather, it just depends on Primerica’s salesforce delivering similar results to the recent past.
Disclosure: Long PRI, PFG
Gator Small Cap Portfolio Starts the Year Off Strong
Mar/102
The Gator Small Cap Portfolio has had strong performance in the first 10 weeks of 2010. Through March 15th, the Gator Small Cap was up 9.3% after fees compared to 7.8% for the Russell 2000® Index. This continues the portfolio’s strong performance from 2009 when it was up 81.6% compared to 25.2% for the Russell 2000® Index.
We had several strong stocks in the portfolio to start the year. Tivo is up 63% year-to-date on the back of a favorable court ruling awarding the company monetary damages for continued infringement of its patents by a competitor. Brink’s Home Security is up 29% after a larger competitor agreed to acquire the company. Also, DineEquity, the franchisor for IHOP and Applebee’s, is up 46% so far in 2010 after reporting stronger earnings and a better than expected outlook for the rest of 2010.
The Gator Small Cap Portfolio holds a concentrated portfolio of 30 stocks of companies with market capitalizations under $3 billion at the time of purchase. We attempt to own smaller companies with strong franchises and business models with favorable economics. We want to hold onto the shares for multiple years to allow the management teams time to compound the strong economics of their businesses. During 2009, we had 30% turnover portfolio holdings.
We believe the Gator Small Cap Portfolio is a unique offering because it is a small cap portfolio offered in separately managed account form. In addition, the portfolio is concentrated which is unusual for a small cap portfolio. Lastly, our account minimum is $100,000, which makes the portfolio available to individuals with modest assets. Our clients may choose any broker or custodian to hold their account. If the client does not have an existing relationship, most of our clients take advantage of our relationship with Fidelity Investments.
Due to the Gator Small Cap Portfolio’s investments in small company stocks and the portfolio’s concentration of holdings, we expect the portfolio to have a much higher degree of volatility than the overall stock market. Please only invest money which you will not need for five or more years. Past performance is not indicative of future results.
Best One Liners from Buffett’s 2010 Shareholder Letter
Mar/101
I always enjoy getting up the first Saturday in March to read Warren Buffett’s annual letter to Berkshire hathaway shareholders. Here are my favorite one liners from this year’s letter:
“I subtly indicated that I was older and wiser…I was just older.”
“If Charlie, I and Ajit are ever in a sinking boat – and you can only save one of us – swim to Ajit.”
“We shouldn’t expect our regulators to live up to their end of the bargain unless we live up to ours.”
“It’s clear that I failed you in letting NetJets descend into this condition. But, luckily, I have been bailed out.”
“There were three ways to cure this overhang: (1) blow up a lot of houses, a tactic similar to the destruction of autos that occurred with the “cash-for-clunkers” program; (2) speed up household formations by, say, encouraging teenagers to cohabitate, a program not likely to suffer from a lack of volunteers or; (3) reduce new housing starts to a number far below the rate of household formations.”
“Our first venture was also christened Berkadia. So let’s call this one Son of Berkadia. Someday I’ll be writing you about Grandson of Berkadia.”
“It’s been an ideal period for investors: A climate of fear is their best friend.”
“In the end, what counts in investing is what you pay for a business – through the purchase of a small piece of it in the stock market – and what that business earns in the succeeding decade or two.”
“It has not been shareholders who have botched the operations of some of our country’s largest financial institutions.”
“In my view a board of directors of a huge financial institution is derelict if it does not insist that its CEO bear full responsibility for risk control.”
“Charlie and I enjoy issuing Berkshire stock about as much as we relish prepping for a colonoscopy.”
“our recommendation in respect to the use of advisors remains: ‘Don’t ask the barber whether you need a haircut.’”
“P.S. Come by rail.”
If you didn’t see your favorite Buffett one liner from this year’s letter, please tell me yours and why in the comment section below.
Buy-and-Hold is not Buy-and-Forget
May/090
The Peridot Capitalist wrote an interesting article defending Buy-and-Hold investing. He argues that Buy-and-Hold doesn’t work if one ignores valuation. I agree with him and would extend his argument to include that we can’t ignore whether a company’s franchise is getting strong and weaker while executing a buy-and-hold strategy. Buy-and-hold, as practiced by Buffett and Munger, involves investing in companies with strong franchises. As time goes by, the franchises either get stronger as profits are reinvested in the business to create a stronger brand or expand distribution or introduce new products, or sometimes, franchises get weaker because of shifts in consumer tastes, increased competition or regulatory changes. Monitoring changes in a company’s franchise strength is an important part of a buy-and-hold strategy.
Using Peridot’s Coke example, not only was valuation stretched in the late 1990s, but Coke’s franchise has weakened. Coke’s major market of carbonated soda drinks (CSDs) has stagnated. Consumers are shifting to healthier non-carbonated drinks such as water, iced tea and sports drinks. Coke missed a major opportunity to buy Gatorade’s parent, Quaker Oats, due to a board revolt against the CEO. Even though the price for Quaker was high at the time, the continued growth of Gatorade may have justified the acquisition. As a franchise like Coke’s gets weaker, investors are less willing to pay high valuations for the stock.
The advantages of Buy-and-Hold are the power of compounding and tax-deferral. Potential Buy-and-Hold investments are companies that can compound their earnings growth at high rates of return for many years. These companies are often in stable businesses or industries. They may have pricing power over their customers or may have recurring revenues under long-term contracts. These companies reinvest their excess profits back into their franchise to make it even stronger. By holding the same stocks for years, investors are getting a interest free loan from the government by not having to pay taxes on gains until the investment is sold.
“Buy-and-hold” is not a “Buy-and-Forget” strategy. As Peridot suggests, the valuation of a stock is extremely important when buying a position. As time passes, investors also need to continually monitor the strength of the company’s franchise. As a company’s franchise weakens or threats to the business franchise emerge, investors should exit these long-term holdings.
At Gator Capital, we follow a buy-and-hold strategy but are rigorous about valuation and franchise strength. We do heavy valuation work prior to entering a position. We also monitor valuation through the life of the investment. We also assess the business franchise of the company and continually monitor the company for any changes in a franchise’s strength.