[Member] HCII is a Buy With a Catalyst Already in Place

This is a past Premium recommendation and is made available for your reference. For more past trades, refer to our trade history.

Homeowners Choice Inc (HCII) is a home owner insurance holding company in Tampa, Florida. Through its various subsidiaries, it provides homeowners’ insurance, condominium owners’ insurance and tenant insurance to property owners in Florida. The company was created in June 2007 through a “take out” program, in which the State of Florida decided to place a part of insurance portfolio it owned through the Citizens Property Insurance Company, a state supported insurer, in private hands as a way of reducing Citizens risk exposure. Over the years, HCII has assumed policies from Citizens in 8 separate transactions. Today, it has 57,000 policies in force, representing $128 million in annualized premiums. 86% of the policies are homeowners’ insurance policies.

Risk wise, Florida is a tough place for insurance due to hurricanes and other catastrophic events. The company manages its risk by ceding a portion of its portfolio to re-insurers for a fee.

The company is relatively young, with just 4 years of operating history. On a valuation basis, the company is a good value based on its financial situation today. The management appears to be competent and conservative and good operators. Additionally, the stock yields about 5.60% in dividends, paid quarterly, and the company has raised the dividend two times in the previous two quarters, expressing their confidence in the strength of their business.

We will discuss the current valuation first. Then we will go into some recent developments that I believe will act as a catalyst to propel the stock much higher.

The Current Valuation of HCII

Using the closing price of $10.75 as of Feb 17, the market value of the company is $65.6 million. This gives it a P/E ratio of 10.97 on a ttm basis. The company operates at a 94.14% combined ratio (as of the quarter ended Sep, 2011), which means it is a profitable business. The company has other income through its investment of the insurance float as well as rental income from its office building and income from operating a marina that it owns. Its net profit margin averages 9.2% in the last 12 months.

(Note: Combined ratio is the sum of Loss ratio and Expense ratio. Loss ratio is the insurance claims paid out per net insurance premiums earned. Expense ratio is the underwriting expense (policy acquisition, employee costs, and other operating expense) per net premiums earned. A combined ratio under 100% reflects a profitable operation)

Here are some of the key balance sheet numbers:

Market Value $65.6 Stock Price $10.75
Book Value $59.17 Price/Book 1.11
Short Term Cash, Investments $116.47 Unearned Cash (pre-paid premiums) $82.87
Cash (net of unearned premiums) $33.6    

 

As far as valuations go, it is in line with the rest of the insurance industry on the book basis. The company has cash which it is using to pay increased dividends to the shareholders. It has also grown its revenues at a rapid clip since inception of the company, primarily by acquiring additional books of business from Citizens.

Catalyst: Homeowners’ Choice is Doubling its Revenues

Effective Nov 1, 2011, Homeowners’ Choice assumed 70,000 policies from HomeWise Insurance Company. In exchange, the company paid $500 for the policies, $250,000 to reimburse HomeWise for the legal and other costs, and issued 1,000,000 warrants to purchase 500,000 shares of HCII at a exercise price of $9.1/share. The company expects these warrants to be valued between $500,000 and $750,000. HomeWise retains a $5.3 million ceding fee for the policies ceded to HCII. The policies assumed represent $106 million in additional revenue for the company annually.

Given that the current 12 month revenues is $75 million, this transaction effectively increases HCII’s business 2.4 times. The company has sufficient free cash on hand to complete the transaction, so I expect the new business to be accretive to the earnings immediately. If the company maintains similar combined ratio, than we are looking at perhaps $6.36 m in additional net income. Company made $6.94 m in N.I in last 12 months so we may be looking at about $13.3 million with the combined business. On a diluted shares basis (and the new warrants issued are dilutive), an eps of $2/share annually looks likely.

Other considerations: As the new policies are assumed, there will be customers who choose not to renew or change their insurance providers. It is reasonable to assume a 10-15% loss in the customer base. Further, the company may have to reduce their rates to entice the customers to stay with HCII. Assuming a 15% decline in revenues from the HomeWise portfolio, we may still be looking at about $1.87/share in full year EPS going forward.

At the P/E ratio of 10, which is a little less that where the stock is today without considering the new business, the stock should be worth $18.7/share as the full year results of the combined business are public (which means in about 5 more quarters).

For this stock I will be willing to pay a price that gives me a 30% margin of safety. With a 1 year target of $18.7, this means a price of $13/share. Further, I will be happy with a 10% return on the stock in 1 year, 5.6% of which comes from the dividends. Discounting $13/share by (10-5.6=4.4%) gives me a buy price of $12.48.

Bottomline

Buy HCII stock at a price below $12.48/share with a target sell price of $18.7/share

Updated Mar 12, 2012: With the recent results and quick integration of Homewise policies, I am comfortable raising my buy price to upto $14/share and the sell target to $22/share.

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