- Atlas Financial is an unusual, uncommoditized niche insurer operating in an extremely attractive segment of the commercial auto sector; specialty light commercial auto (taxis, limousines, paratransit).
- The company's small size and inauspicious beginnings lead to a wide market misunderstanding, still persisting as the group begins to deliver on its ambitious growth and return targets.
- Prospective investors are now able to buy into a clear growth runway, improving prospects in Atlas's insurance segment and a balance sheet with the "heavy lifting" already done.
- On a conservative base scenario, we believe Atlas presents an extremely attractive 2-year return (100%+) - with potential for considerable further upside. The stock trades at ~11x our earnings estimate.
Background & History
Atlas Financial (NASDAQ:AFH) is a collection of insurance brands operating in the same niche - the "light commercial" segment, focusing on the passenger transportation industry. Obviously, this is predominantly made up of taxis and limousines, though an increasing amount of the business it writes is made up of paratransit - transportation services for people with disabilities, or who need particular care (such as elderly patients).
The group was spun out of Kingsway (NYSE:KFS), a large insurance conglomerate, in 2010. This - its beginning as an independent firm - came after years of stagnation as part of the larger corporate entity; Kingsway, having fallen into financial distress after a series of expensive acquisitions and aggressive premium growth, had starved insurance subsidiaries of capital as the belt began to tighten; in 2010, Atlas was writing less than a fifth of the premium it had 5 years earlier.
Realizing that Atlas was something of a gem in the midst of a messy whole, the restructuring team at Kingsway - including current CEO Scott Wollney - separated Atlas from its parent, though Kingsway maintained a significant chunk of the equity. Management also put up millions to take a stake in the new business.
Since then, operations have been driven by the recapture of business lost during their period of capital starvation; the group ran an operating structure too big for its existing level of premium post spin-out, as it anticipated significant growth. It has now been vindicated on that front - so though the past looks messy, those willing to look past the noise will find a solid underlying business finally on a sound footing.
How the market views Atlas
We think there are a few reasons Atlas is underappreciated by the market. A good starting point, then, is addressing these issues, and then laying out our case for why Atlas is such a compelling investment.
1. On the archetypal insurance valuation metric, price-to-book, Atlas is expensive
Reason: Insurance companies are typically valued on a price-to-book basis, similar to banks. The logic is generally that, as companies occupying a heavily commoditized sector (it's very difficult to differentiate insurance products) and a very capital intensive one, the best guide to an insurer's value is the equity on its balance sheet. The equity on its balance sheet will dictate the premium it can write (and hence its premium income) and the investment income it receives.
Answer: This logic holds if you hold one important metric constant - return on equity. If you assume all companies earn a "market" return on equity - that no one has a competitive edge - all companies will be worth book. As we'll discuss later, though, there are both quantitative (it is already doing it) and qualitative (there are good reasons to believe it) factors that should allow Atlas to earn RoEs significantly above its peer group. And as soon as that happens - particularly if you combine it with high levels of growth - price to book becomes a poorer yardstick of value.
2. Uber is shaking up the passenger transportation industry
Reason: Comments about Uber are typically one of the first things people bring up when talking about any company which works in the industry of moving people from A to B. As the traditional taxi industry faces significant headwinds, isn't there a danger in being involved with any company which helps to service that sector?
Answer: We think the Uber issue is a complete red herring. We have yet to meet anyone who thinks that a realistic endgame to the battles around Uber is a situation where large fleets of unregulated taxis are able to operate without insurance. This seems to be something Uber is well aware of itself - it notes that "getting insurance right is probably the thorniest issue" it is facing. Given Atlas's focus on the small fleet-size end of the market, the creation of a broader base of taxi drivers who drive less - as well as Atlas's long history of underwriting experience and how to figure out how best way to price risk - might even make Uber a growth opportunity for it.
3. Rapid growth in insurers is always treated with a pinch of salt
Reason: Insurers which grow particularly quickly are always treated with a deep sense of skepticism by the market, for a number of good reasons. Insurance is an easy industry to grow in - you can just appoint agents and tell them to go out and write premium. Even worse, your mistakes are never obvious until years later - see Kingsway for an example - as insurance accounting is always a best guess of the truth.
Answer: Insurance blow-ups tend to have a few things in common, but one of them is a predominance of "long-tail" lines of insurance - insurance whereby you price the risk at one point and the cost of that risk only becomes obvious in several years' time. Atlas does not have this characteristic. Not only are its brands long-standing, and so able to price risk extremely accurately, the type of insurance it writes is inherently short-lived; 12-month policies on vehicles which tend to have a high accident-rate and only a small tail of litigation claims. On top of that, it reinsures its catastrophe risk, meaning it passes on the risk that it has no genuine advantage in pricing.
The business environment
Our first point above was that valuing Atlas on a price-to-book measure isn't fair, because price to book only works in commoditized insurance segments where no genuine competitive advantage exists. Our next point was that if a company can combine strong RoEs with a high potential growth rate, it is able to create truly substantial value. Let's dive into both of those points.
What makes Atlas's insurance segment so attractive? Where is its competitive moat? The best way to think about this, we feel, is to compare and contrast with more competitive insurance lines - like general public automobile insurance.
For a start, light commercial auto insurance is a small market. Passenger auto is an enormous market - and one that is dominated by "light touch" insurance operators. Head online, enter details, buy a policy, finish. Clearly, this market dynamic lends itself to larger corporations which want to put a lot of capital to work - since it's relatively easy to be sharper on your pricing and begin to take in enormous premium volumes. Atlas estimates that the entire niche in which it operates is worth $2bn. Even a large chunk of this market is small fry for a big insurer, and not an easy segment to begin to attack. Why?
Well, commercial auto insurance is highly transactional and bears a high cost of failure for the operator. A taxi operator insuring his fleet expects to have a sizeable number of accidents over the year - and every day a taxi is out of operation is a day he is losing money. Hence, having a streamlined claims process and getting the problem sorted as quickly as possible is paramount. Obviously, this makes it an operationally intensive business.
The sales process is also relevant. Atlas sells through agents who recognize its position as the premium insurance provider - the one which provides the lowest all-in costs, because it turns around customer fleets and allow them to operate more efficiently. Given that the predominant reason insureds change agents is because of a bad claims experience - leading them to blame everyone in the chain - agents value Atlas's quick claim handling and domain expertise. Naturally, given that they take home percentage-based commission on sales, they're also monetarily incentivized to sell Atlas vs. their more budget peers.
Finally, there's the market position and underwriting data that Atlas possesses. Atlas is the only national brand focused on the light commercial auto segment, mainly competing with either small regional players (smart but sub-scale) or large generalists who write through general managing agents (inefficient and far too pro-cyclical). It has decades of underwriting experience in this particular segment, including, for instance, on the legal/personal injury side of things. A significant chunk of cost for any automobile insurer is legal costs related to claims from other parties - some spurious, some not. Atlas, with its history - and partly due to its position as being a trusted partner to both agents and insureds - has the data and capacity to evaluate legal cases and either settle or help drivers aggressively fight, depending on the likelihood of success. The standard "fight all" or "settle all" policy of those without the deep legal knowledge Atlas possesses is clearly a sub-optimal strategy. This is just one example of how Atlas's niche focus allows it to maintain a competitive edge.
As an aside, for those who buy the market dynamics, but not the market size argument, and think competition is likely - consider the strategic logic for a large company choosing to attack Atlas's lucrative corner of the market - they could try underwriting themselves, set up all the expensive infrastructure and wait years for sufficient premium/data/underwriting experience to justify their existence… or they could just buy Atlas, particularly at the current valuation. We know which one we would choose.
Performance and financials
Earlier this month, we got Atlas's full-year 2014 figures, beating expectations and confirming another year of substantial growth, mainly driven by recapture business - business from agents it used to supply before the period of capital starvation in Kingsway.
The highlights were as follows:
- Gross written premium up by 31.6% as market share and geographic spread grow.
- Combined ratio down to hit 88.4% in Q4, and pricing continuing to firm.
- Completion of acquisition of complementary New York taxi insurance business for just over book value.
- RoAE (return on average equity) of 16.4% in Q4 even with some slack in capacity, and pricing suggests improvements still working through. Large insurers are happy to manage 10% across the cycle.
- Renewal retention ratio above 85%, implying potential for increased pricing.
For those unfamiliar with insurance terminology, the combined ratio is essentially the expected profitability of the insurance policies you are taking on. It is calculated by comparing the premium earned from a policy with the loss ratio - expected costs relating to incidents for policyholders - and other underwriting expenses, which capture the general cost of capturing business and administration on the back end. Atlas also splits out its customer acquisition cost. A combined ratio of 88.4% is fantastic for the insurance market generally - it implies that for every $100 of premium you write, you make $11.60 of profit, before taking into account the money you'll make by investing that premium. Positively, the combined ratio is trending better, too:
The graph below shows the combined ratio of last year and the year before, as well as my estimate of the ratio for business it is currently writing - which should give us some insight into the outturn for full-year 2015.
On top of that, it also shows the ratio in 3 scenarios outlined in the group's investor deck - a "soft" or "hard" market, depending essentially on the level of capital floating around from large insurers, which puts pressure on rates. On this front, the group is pretty happy - several generalists have been winding down their programs, allowing Atlas to ratchet up pricing while continuing to gain market share. Management is bullish on an ongoing improvement in rates, and hence the combined ratio.
(click to enlarge)
The "hard" market scenario above isn't pie in the sky, either; in the last hard market cycle the group experienced, the business was writing at loss ratios consistent with the figures above. Whether we'll get back there is debatable, but it creates a nice upside scenario.
Management guidance in the Q4 conference call was positive - along with the optimistic guidance for rates and combined ratios in 2015, Wollney also stated that it expected 30-50% growth in organic premiums. Including the $40MM of premium acquired in the recent Global Liberty acquisition, the top end of its targets could leave the group over twice as big as it was last year.
Crucially, it's important to note that both the infrastructure and the capital for this growth have already been secured, as well as an equity raise last year. The group recently announced a new debt capital - a revolving credit facility, for which $30MM can be used as funds in insurance subsidiaries. It also signed a broad quota-share reinsurance policy with Swiss Re (OTCPK:SSREY), allowing it to reinsure 5-50% of its business. This gives the group a significant amount of "flex" to meet even a more aggressive growth path than the one it has guided to, and allows the group to more efficiently manage capital given the lumpy nature of block debt and equity issuance.
That being said, it is important to note that the thrust of the growth strategy has shifted somewhat, from recapture of old business to a more aggressive roll-out of new business, and an increased capture of share with existing agents. The group notes that:
"In recent years an important aspect of our growth strategy was to recapture business through this core group of agents as our company expanded and competitors pulled out of the market.""10 years ago these agents were writing more than 125 million in very few states with only two of our subsidiaries. Today, we're currently licensed in 49 states and actively distribute products in 40 states, plus Washington D.C. In 2015, our operating platform will include foreign insurance companies with a strong heritage that are well known to our distribution channel and customer base."
Put simply, it doesn't think its target of "proportionate market share" - currently about $400MM - is unduly ambitious. While the past was driven by recapture, it now has the footprint in place to roll out more aggressively on a national basis, increasing share in markets where it is as-yet relatively underpenetrated.
Modelling & Valuation
Let's take everything we've said so far and tie it to both the current market price and our estimate of the group's fair value.
To start - the valuation the group is trading at on the market. While we criticized the use of price-to-book ratios when evaluating Atlas earlier, in this case, price-to-earnings ratios are also difficult - last year's earnings figure includes a number of one-off tax effects and do not include the Global Liberty acquisition concluded early in this financial year. The forward P/E ratio - as assumed by brokers - is better, but also suffers from a timing issue when applied to a growing insurance company. That is, while the company is growing, accounting profits will lag economic profits, as the group books in an increasing rate of business but recognizes a relatively smaller portion of it in the current accounting period.
For this reason, we use a 2-year-out earnings model to approximate Atlas's fair value. In this simplified version, we leave out the balance sheet, besides using sanity checks to ensure that the group is adequately capitalized to write the business the growth projections are assuming without further debt or equity.
(click to enlarge)
We recommend, for those interested, the creation of your own model with Atlas - playing around with combined ratios, the level of premium growth and exit multiples will be instructive in thinking about how to value the business. Regarding our snapshot above, we will note a few things:
- We suspect the level of premium growth, while being assuredly fast and in line with management's guidance for at least next year, to be below management's ambitions. We haven't really flexed management's reinsurance lever at all (keeping it at the minimum level of 5%) and have been repaying the revolver.
- Management's stated aim of "proportionate market share" - $400MM - is still some way off, particularly with a slowing growth rate.
- Loss ratios are relatively aggressive - this would require a continuation of the current firm markets the group is seeing for a couple years, but no improvement (in fact a slight worsening). Early signs are positive on this front, but it is still a risk factor...
- … though investment returns are assumed to remain terrible, due to compressed bond yields. A rising interest rate environment might provide some upside on this front. Indicatively, a 1% increase in investment yields in 2016 would increase our net profit estimate by 10-15%.
- Finally, the exit multiple seems modest to us for a company growing quickly, profitably, and with best-in-class returns.
As hinted at above, while we think there are a number of reasons why investors might be more bullish than our assumptions, the real risk factor is around loss ratios. Insurance markets are fickle, and we are cognizant of the fact that markets can turn quickly if - for whatever reason - the current trend reverses and capital begins to flood back in.
The company's own estimates indicate that, in this scenario, the combined ratio would compress to a much less profitable 95-97, leaving the group's returns on equity back down in far more normal territory. Notwithstanding the group's still-favourable dynamics looking ahead to a market turn, we would find it much more difficult to set out our stall and persuade the market to attempt to value the group at meaningfully more than book. We estimate that this would see about 50% downside, though would stress that we would likely see considerable value in the company in this scenario based on market myopia.
But there is a reason to be positive about the potential for a market decline in Atlas's segments - and that's management's superb history of capital allocation and company turnarounds. So far in this article, we have almost entirely focused on capital allocation in terms of writing more premium, which is the company's current focus given the good and improving rate environment. Make hay while the sun shines. However, there is another critical pillar of group strategy. From its Q4 conference call:
"…finding and fixing challenge insurance companies, and always being a good steward of capital""softening seen in other commercial insurance areas will likely lead to the kind of challenges that we will exploit…"
The Gateway acquisition, completed by Atlas in 2013, was a great example of this - a core light commercial auto business that was attractive and accretive to Atlas made messy by an expansion into other lines of insurance outside of company expertise. Atlas restructured, moved capital appropriately, and integrated cheaply. Given the structure of Atlas's insurance segment - regional, small players - there's every reason to think that it will be able to do this again in future downturns - only with more firepower behind it.
Conclusion
How do you value good capital allocation, optionality in a downside scenario and an aligned management team? These kinds of soft factors are always difficult for investors to appraise.
In Atlas's scenario, though, we don't feel like we have to - because we're getting the company, as it stands today, with considerable industry tailwinds, for a cheap price. All the rest of the perks are for free.
Our base scenario represents a 3-digit percentage upside in less than 2 years. Our bull case, should the stars align, is significantly better. Our bear case gives a level of downside we're comfortable with given the asymmetry of the bet, but also creates opportunities for a group with management pedigree in good capital allocation, acquisition and turnaround.
We think that's a great formula
Source: http://seekingalpha.com/article/3055986-atlas-financial-holdings-a-cheap-niche-insurer-with-runaway-growth
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